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Exchange Rate Dynamics under Alternative Optimal Interest Rate Rules

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  • Mahir Binici
  • Yin-Wong Cheung

Abstract

We explore the role of interest rate policy in the exchange rate determination process. Specifically, we derive exchange rate equations from interest rate rules that are theoretically optimal under a few alternative settings. The exchange rate equation depends on its underlying interest rate rule and its performance could vary across evaluation criteria and sample periods. The exchange rate equation implied by the interest rate rule that allows for interest rate and inflation inertia under commitment offers some encouraging results – exchange rate changes “calibrated” from the equation have a positive and significant correlation with actual data, and offer good direction of change prediction. Our exercise also demonstrates the role of the foreign exchange risk premium in determining exchange rates and the difficulty of explaining exchange rate variability using only policy based fundamentals.

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Paper provided by Research and Monetary Policy Department, Central Bank of the Republic of Turkey in its series Working Papers with number 1116.

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Date of creation: 2011
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Handle: RePEc:tcb:wpaper:1116

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Keywords: Taylor Rule; Exchange Rate Determination; Mean Squared Prediction Error; Direction of Change; Foreign Exchange Risk Premium;

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Cited by:
  1. Mark Gertler & Jordi Gali & Richard Clarida, 1999. "The Science of Monetary Policy: A New Keynesian Perspective," Journal of Economic Literature, American Economic Association, vol. 37(4), pages 1661-1707, December.
  2. Virtue Ekhosuehi & Sunday Ogbonmwan, 2014. "Determination of the optimal exchange rate via control of the domestic interest rate in Nigeria," Operations Research and Decisions, Wroclaw University of Technology, Institute of Organization and Management, vol. 1, pages 23-36.
  3. Chen, Qianying, 2011. "Exchange rate dynamics, expectations, and monetary policy," Discussion Paper Series 1: Economic Studies 2011,18, Deutsche Bundesbank, Research Centre.

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