Monetary Shocks and the Fundamental Determinants of the Real Exchange Rate under the Hong Kong Currency Board

To assess the claim that flexible markets render monetary policy unimportant under the currency board, we test the impact of monetary shocks on Hong Kong's real exchange rate. Using vector autoregressions, we find persistent effects of monetary shocks on the real exchange rate, implying money is not neutral in Hong Kong. We then estimate the equilibrium real exchange rate, employing the definition developed by Rogoff-Obstfeld-Stein. The divergence between the observed and equilibrium rates is clearly stationary throughout the 1980s, but after a key policy shift in 1991 that divergence becomes non-stationary. We conclude that Hong Kong's real exchange rate moved away from the real fundamentals in the latter period.