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Home bias, exchange rate disconnect, and optimal exchange rate policy

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  • Wang, Jian

Abstract

This paper examines how much the central bank should adjust the interest rate in response to real exchange rate fluctuations. The paper first demonstrates, in a two-country Dynamic Stochastic General Equilibrium (DSGE) model, that home bias in consumption is important to replicate the exchange rate volatility and exchange rate disconnect documented in the data. When home bias is high, the shock to Uncovered Interest rate Parity (UIP) can substantially drive up exchange rate volatility while leaving the volatility of real macroeconomic variables, such as GDP, almost untouched. The model predicts that the volatility of the real exchange rate relative to that of GDP increases with the extent of home bias. This relation is supported by the data. A second-order accurate solution method is employed to find the optimal operational monetary policy rule. Our model suggests that the monetary authority should not seek to vigorously stabilize exchange rate fluctuations. In particular, when the central bank does not take a strong stance against the inflation rate, exchange rate stabilization may induce substantial welfare loss. The model does not detect welfare gain from international monetary cooperation, which extends Obstfeld and Rogoff's [Obstfeld, M., Rogoff, K.,2002. Global implications of self-oriented national monetary rules, Quarterly Journal of Economics May, 503-535] findings to a DSGE model.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of International Money and Finance.

Volume (Year): 29 (2010)
Issue (Month): 1 (February)
Pages: 55-78

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Handle: RePEc:eee:jimfin:v:29:y:2010:i:1:p:55-78

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Web page: http://www.elsevier.com/locate/inca/30443

Related research

Keywords: Home bias Exchange rate volatility Exchange rate disconnect Optimal monetary policy;

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References

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Cited by:
  1. Simon Wren-Lewis & Campbell Leith, 2007. "The Optimal Monetary Policy Response to Exchange Rate Misalignments," Economics Series Working Papers 305, University of Oxford, Department of Economics.
  2. Stephen McKnight, 2007. "Investment and Interest Rate Policy in the Open Economy," Economics & Management Discussion Papers em-dp2007-51, Henley Business School, Reading University.
  3. Charles Engel, 2009. "Currency Misalignments and Optimal Monetary Policy: A Re-examination," RBA Research Discussion Papers rdp2009-01, Reserve Bank of Australia.
  4. Xu, Juanyi, 2010. "Noise traders, exchange rate disconnect puzzle, and the Tobin tax," Journal of International Money and Finance, Elsevier, vol. 29(2), pages 336-357, March.
  5. Engel, Charles & Wang, Jian, 2011. "International trade in durable goods: Understanding volatility, cyclicality, and elasticities," Journal of International Economics, Elsevier, vol. 83(1), pages 37-52, January.
  6. Juha Tervala, 2011. "International Welfare Effects of Monetary Policy," Discussion Papers 66, Aboa Centre for Economics.
  7. Charles Engel & Jian Wang, 2007. "International trade in durable goods: understanding volatility, cyclicality, and elastics," Globalization and Monetary Policy Institute Working Paper 03, Federal Reserve Bank of Dallas.
  8. Teresa Sousa, 2011. "International macroeconomic interdependence and imports of oil in a small open economy," Portuguese Economic Journal, Springer, vol. 10(1), pages 35-60, April.
  9. Charles Engel, 2013. "Exchange Rates and Interest Parity," NBER Working Papers 19336, National Bureau of Economic Research, Inc.

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