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Rational expectations, changing monetary policy rules, and real exchange rate dynamics

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  • Chen, Shiu-Sheng
  • Chou, Yu-Hsi

Abstract

This paper reexamines the explanatory power of Taylor rule fundamentals for real exchange rate determination. We assume the agents know the time-varying parameters in central bank policy rules. The empirical results suggest that a monetary policy rule with regime switching is better able to explain the real Deutschemark/dollar exchange rate from 1976 to 1998 compared with a fixed-regime monetary policy rule. The findings show the importance of accounting for the expectation formation effect in changing policy rules as emphasized by the Lucas critique. Ignoring these effects can undermine the value of the rational expectations models.

Suggested Citation

  • Chen, Shiu-Sheng & Chou, Yu-Hsi, 2012. "Rational expectations, changing monetary policy rules, and real exchange rate dynamics," Journal of Banking & Finance, Elsevier, vol. 36(10), pages 2824-2836.
  • Handle: RePEc:eee:jbfina:v:36:y:2012:i:10:p:2824-2836
    DOI: 10.1016/j.jbankfin.2012.06.013
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    References listed on IDEAS

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    Keywords

    Rational expectations; Real exchange rate; Taylor rule;

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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