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

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  • Jian Wang

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 the home bias in consumption is important to duplicate 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 the volatility of the real exchange rate relative to that of GDP increases with the extent of home bias. This relation is strongly supported by the data. Then a second-order accurate solution method is employed to solve the model and compare the conditional welfare under different policy regimes. The results suggest 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 also suggests no welfare gain from the international monetary cooperation, which extends Obstfeld and Rogoff's (2002) findings to a DSGE model.

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Paper provided by Federal Reserve Bank of Dallas in its series Working Papers with number 0701.

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Date of creation: 2007
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Handle: RePEc:fip:feddwp:0701

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Cited by:
  1. Cambell Leith & Simon Wren-Lewis, 2006. " The Optimal Monetary Policy Response to Exchange Rate Misalignments," CDMA Conference Paper Series 0605, Centre for Dynamic Macroeconomic Analysis.
  2. Charles Engel, 2009. "Currency Misalignments and Optimal Monetary Policy: A Re-examination," RBA Research Discussion Papers rdp2009-01, Reserve Bank of Australia.
  3. Stephen McKnight, 2007. "Investment and Interest Rate Policy in the Open Economy," Economics & Management Discussion Papers em-dp2007-51, Henley Business School, Reading University.
  4. 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.
  5. Charles Engel, 2013. "Exchange Rates and Interest Parity," NBER Working Papers 19336, National Bureau of Economic Research, Inc.
  6. 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.
  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. Tervala, Juha, 2012. "International welfare effects of monetary policy," Journal of International Money and Finance, Elsevier, vol. 31(2), pages 356-376.
  9. 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.

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