Changing Monetary Policy Rules, Learning, and Real Exchange Rate Dynamics

Abstract

When the exchange rate is priced by uncovered interest parity and central banks set nominal interest rates according to a reaction function such as the Taylor rule, the real exchange rate will be determined by expected inflation and the output gap or the unemployment gap of the home and foreign countries. This paper examines the implications of these Taylor rule fundamentals for real exchange rate determination. Because the true parameters in central bank policy rules are unknown to the public and change over time, the model is presented in the context of a least squares learning environment. This simple learning model captures the volatility and the major swings in the real deutschemark/euro-dollar exchange rate from 1976 to 2007. Copyright (c) 2009 The Ohio State University.

Trend Fundamentals and Exchange Rate Dynamics

“…Using the benchmark model we obtain correlations between 0.22 for the UK and 0.48 for Canada. The correlation for Germany at 0.35 is close to existing estimates by Engel and West (2006) and Mark (2009).…”

Common factors and the exchange rate: results from the Brazilian case

“…If the exchange rate is the expected present discounted value of current and future fundamentals it is possible that the evolution of the exchange rate is affected not only by the dynamics of observables fundamentals like monetary aggregates, price level, or output, but also by unobservable variables such as risk premium or noise trading. As discussed by Engle, Mark (2008), if these unobservable factors have little correlation with the observable, this reduces the predictive power of the models, leading to the weak results found in the literature. 3 Bacchetta and van Wincoop (2004), Bacchetta (2011) developed the scapegoat theory, which is consistent with this role of unobservable variables in explaining movements of the exchange rate.…”

“…stability in forecasting the exchange rate. Evans and Lyons (2002, 2008 and Chinn and Moore (2010) adopt a microstructure approach to the traditional macroeconomic models with the objective of answering this question. In these papers, the inclusion of order flow variables would solve the problem of the conventional models because these variables would account for shocks that lead to instability in the relationship between the exchange rate and fundamentals.…”

Micro Approaches to Foreign Exchange Determination

“…Second, information known to dealers will only be embedded in the spot exchange rate if they find it optimal from a 3 Notice that we focus here only on the terms involving macro fundamentals, or equivalently on circumstances where rt = r * t and δt = 0. 4 See, for example, Engel and West (2006) and Mark (2009). Chapter 3 in Evans (2011) contains a detailed discussion of this point.…”