The Exchange Rate as an Adjustment Mechanism: A Structural VAR Approach to the Case of Ireland

Abstract

Ireland's participation in stage three of Economic and Monetary Union precludes exchange rate adjustment in response to asymmetric shocks. A Structural VAR model is used to decompose the effects of asymmetric supply, demand and nominal disturbances on macroeconomic imbalances between Ireland and the UK and on the Irish pound-sterling exchange rate. The results indicate that supply shocks account for a significant degree of the fluctuation in both variables. This lends weight to the view that the loss of autonomous control over the nominal exchange rate in the face of asymmetric shocks is a significant one, thus increasing the importance of alternative adjustment mechanisms for the Irish economy.