exchange rate regime, this results in an exchange rate appreciation, which then leads to an eventual reduction in overall prices.

Many earlier studies, however, point out that the conditional movements of foreign exchange rates exhibit puzzling deviations from the theoretical predictions (Clarida et al. 2001; Eichenbaum and Evans 1995; Scholl and Uhlig 2008; among others). For instance, with a positive domestic monetary shock, the currency either depreciates, exhibiting the so-called foreign exchange rate puzzle, or appreciates only gradually over prolonged periods, a phenomenon known as delayed overshooting.<sup>41</sup> The evidence of the FX puzzle persists in more recent literature. While there is mixed evidence concerning advanced economies, the puzzle is more prevalent in the case of EMEs (Obstfeld et al. 2019; Kohlscheen 2014; Kim and Lim 2018). Based on a meta-analysis, Hnatkovska et al. (2012; 2016) summarize that the exchange rate depreciates due to positive shocks to the interest rate differential in 37 out of 49 developing countries.

In a study of Brazil, Mexico, and Chile, Kohlscheen (2014) finds that even when focusing on 1-day exchange rate changes following policy events—which reduces the potential for reverse causality considerably— there is no support for the view that associates unexpected interest rate hikes with immediate appreciations. Brandao-Marques et al. (2020) similarly find that the effects on prices of a contractionary monetary policy shock are more muted and only significant when accounting for the exchange-rate channel. The authors argue that the behavior of the exchange rate could be a main reason behind countries’ heterogeneous responses to monetary policy shocks (e.g., also shown in Ehrmann et al. 2011; Kim and Roubini 2000), potentially accounting for the price puzzle. The transmission of a monetary policy shock to output and prices is statistically different from estimates obtained when excluding the amplification mechanism through exchange rates.

Existing studies attribute the exchange rate puzzle in EMEs to various underlying factors—including concerns over debt financing, habit persistence of exchange rates, disconnection between bond and currency markets, and the response of liquidity problems following monetary policy shocks. The latter, often referred to as “UIP premium puzzle,” has been considered one of the most compelling reasons for the disconnection between interest rates and exchange rates. Kohlscheen (2014) argues that it is difficult to attribute the exchange rate puzzle solely to fiscal dominance, as unexpected rate increases are not associated with increases in risk premia. Similar results are obtained in the case of Chile—a country with the highest possible short-term credit rating since 1995 and a debt/GDP ratio below 10%. Instead, De Leo et al. (2023) find, by examining quarterly data from the mid-1990s to 2019 across a large set of EMEs, that monetary policies in EMEs tend to adopt Taylor-rule-like approaches but still exhibit a procyclical nature. They argue that one of the primary reasons for this phenomenon is the disconnect between policy rates and short-term market rates in EMEs.

Blanchard (2004) argues that if an increase in the real interest rate also raises the likelihood of default on debt, it may diminish the attractiveness of domestic government debt, resulting in a real depreciation. This scenario is more likely with higher initial debt levels, a larger proportion of foreign-currencydenominated debt, and heightened risk premiums. In such a context, inflation targeting can yield counterintuitive effects: a rise in the real interest driven by monetary policy responding to higher inflation

> 41 In the case of EMEs, earlier studies based on event studies with _daily_ data show that the currency response to monetary policy is low or nonexistent (Aktas et al. 2005; Duran et al. 2012; Pennings et al. 2015).

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