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

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  • 1

    See Mark (1995), Mark and Sul (2001), Groen (2000, 2002), and Rapach and Wohar (2002) who report econometric evidence on the long-horizon predictability of exchange rate returns from standard macropricing errors. The relation between exchange rates and levels of macrofundamentals is predicted by theory ranging from disequilibrium Keynesian models of Dornbusch (1976), Mussa (1982), and Obstfeld (1985) to the new open-economy macroeconomics of Obstfeld and Rogoff (1995).

  • An earlier version of this paper was presented at Mussafest, a conference in honor of Michael Mussa's 60th birthday. I thank Mohan Kumar and Young-Kyu Moh for useful comments. This paper has also benefited from presentations at the University of Auckland, the 5th Missouri Economics Conference, the World Congress of the Econometric Society, the University of Houston, the 39th Konstanz seminar, and Tulane University. Financial support from the National Science Foundation is gratefully acknowledged. The generous and helpful comments from two anonymous referees led to a significant improvement in the paper.

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.

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