IDEAS home Printed from
MyIDEAS: Login to save this article or follow this journal

Optimal monetary policy under heterogeneity in currency trade

  • Mikael Bask

Purpose – Questionnaire surveys made at currency markets around the world reveal that currency trade to a large extent not only is determined by an economy's performance or expected performance. Indeed, a fraction is guided by technical trading, which means that past exchange rates are assumed to provide information about future exchange rate movements. The purpose of this paper is to ask how a successful monetary policy should be designed when technical trading in the form of trend following is used in currency trading. Design/methodology/approach – The paper embeds an optimal policy rule into Galí and Monacelli's dynamic stochastic general equilibrium (DSGE) model for a small open economy, which is augmented with trend following in currency trading, to examine the prerequisites for a successful monetary policy. Specifically, the conditions for a determinate rational expectations equilibrium (REE) that also is stable under least squares learning are in focus. The paper also computes impulse-response functions for key variables to study how the economy returns to steady state after being hit by a shock. Findings – The paper finds that a determinate REE that also is stable under least squares learning often is the outcome when there is a limited amount of trend following in currency trading, but that a more flexible inflation rate targeting in monetary policy sometimes cause an indeterminate REE in the economy. Thus, strict, or almost strict, inflation rate targeting in monetary policy is recommended also when there is technical trading in currency trading and not only when all currency trading is guided by fundamental analysis (in the form of rational expectations). This result is a new result in the literature. Originality/value – There are already models in the literature on monetary policy design that incorporate technical trading in currency trading into an otherwise standard DSGE model. There is also a huge amount of DSGE models in the literature in which monetary policy is optimal. However, the model in this paper is the first model, to the best of the author's knowledge, where technical trading in currency trading and optimal monetary policy are combined in the same DSGE model.

If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.

File URL:;jsessionid=77548A451D84DF9FDB5A078EE9DE462B?contentType=Article&contentId=1860345
Download Restriction: Cannot be freely downloaded

As the access to this document is restricted, you may want to look for a different version under "Related research" (further below) or search for a different version of it.

Article provided by Emerald Group Publishing in its journal Journal of Financial Economic Policy.

Volume (Year): 1 (2009)
Issue (Month): 4 (May)
Pages: 338-354

in new window

Handle: RePEc:eme:jfeppp:v:1:y:2009:i:4:p:338-354
Contact details of provider: Web page:

Order Information: Postal: Emerald Group Publishing, Howard House, Wagon Lane, Bingley, BD16 1WA, UK
Web: Email:

References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:

as in new window
  1. Lars E.O. Svensson, 2002. "What Is Wrong with Taylor Rules? Using Judgment in Monetary Policy through Targeting Rules," Working Papers 118, Princeton University, Department of Economics, Center for Economic Policy Studies..
  2. Blanchard, Olivier Jean & Kahn, Charles M, 1980. "The Solution of Linear Difference Models under Rational Expectations," Econometrica, Econometric Society, vol. 48(5), pages 1305-11, July.
  3. George W. Evans & Seppo Honkapohja, 2003. "Adaptive learning and monetary policy design," Proceedings, Federal Reserve Bank of Cleveland, pages 1045-1084.
  4. Yin-Wong Cheung & Menzie D. Chinn, 2000. "Currency Traders and Exchange Rate Dynamics: A Survey of the U.S. Market," CESifo Working Paper Series 251, CESifo Group Munich.
  5. Brock, W.A. & Hommes, C.H., 1996. "A Rational Route to Randomness," Working papers 9530r, Wisconsin Madison - Social Systems.
  6. Honkapohja, Seppo & Evans, George W., 2000. "Expectations and the stability problem for optimal monetary policies," Discussion Paper Series 1: Economic Studies 2000,10, Deutsche Bundesbank, Research Centre.
  7. Woodford, Michael, 1999. "Optimal monetary policy inertia," CFS Working Paper Series 1999/09, Center for Financial Studies (CFS).
  8. repec:tpr:qjecon:v:115:y:2000:i:1:p:147-180 is not listed on IDEAS
  9. Evans, George W. & Honkapohja, Seppo, 2002. "Monetary policy, expectations and commitment," Working Paper Series 0124, European Central Bank.
  10. Menkhoff, Lukas, 1997. "Examining the Use of Technical Currency Analysis," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 2(4), pages 307-18, October.
  11. Evans, George W. & Honkapohja, Seppo, 2003. "Freidman's Money Supply Rule versus Optimal Interest Rate Policy," CEPR Discussion Papers 3883, C.E.P.R. Discussion Papers.
  12. Richard Clarida & Jordi Galí & Mark Gertler, 1997. "The science of monetary policy: A new Keynesian perspective," Economics Working Papers 356, Department of Economics and Business, Universitat Pompeu Fabra, revised Apr 1999.
  13. Tesfatsion, Leigh & Judd, Kenneth L., 2006. "Handbook of Computational Economics, Vol. 2: Agent-Based Computational Economics," Staff General Research Papers 10368, Iowa State University, Department of Economics.
  14. Svensson, Lars E. O., 2002. "Inflation targeting: Should it be modeled as an instrument rule or a targeting rule?," European Economic Review, Elsevier, vol. 46(4-5), pages 771-780, May.
  15. Mikael Bask, 2007. "Chartism and exchange rate volatility," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 12(3), pages 301-316.
  16. Richard Clarida & Jordi Gali & Mark Gertler, 2001. "Optimal Monetary Policy in Open versus Closed Economies: An Integrated Approach," American Economic Review, American Economic Association, vol. 91(2), pages 248-252, May.
  17. Taylor, John B., 1993. "Discretion versus policy rules in practice," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 39(1), pages 195-214, December.
  18. Taylor, Mark P. & Allen, Helen, 1992. "The use of technical analysis in the foreign exchange market," Journal of International Money and Finance, Elsevier, vol. 11(3), pages 304-314, June.
  19. Richard Clarida & Jordi Gali & Mark Gertler, 1998. "Monetary Policy Rules and Macroeconomic Stability: Evidence and Some Theory," NBER Working Papers 6442, National Bureau of Economic Research, Inc.
  20. Bennett T. McCallum, 2006. "E-Stability vis-a-vis Determinacy Results for a Broad Class of Linear Rational Expectations Models," NBER Working Papers 12441, National Bureau of Economic Research, Inc.
  21. Thomas Gehrig & Lukas Menkhoff, 2006. "Extended evidence on the use of technical analysis in foreign exchange," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 11(4), pages 327-338.
  22. Eric Schaling & James Bullard, 2005. "Monetary Policy, Determinacy, and Learnability in the Open Economy," Computing in Economics and Finance 2005 362, Society for Computational Economics.
  23. Cars H. Hommes, 2005. "Heterogeneous Agent Models in Economics and Finance," Tinbergen Institute Discussion Papers 05-056/1, Tinbergen Institute.
  24. Luis Gonzalo Llosa & Vicente Tuesta, 2006. "Determinacy and Learnability of Monetary Policy Rules in Small Open Economies," Research Department Publications 4479, Inter-American Development Bank, Research Department.
  25. James B. Bullard, 2006. "The learnability criterion and monetary policy," Review, Federal Reserve Bank of St. Louis, issue May, pages 203-217.
  26. Christopher J. Neely, 1997. "Technical analysis in the foreign exchange market: a layman's guide," Review, Federal Reserve Bank of St. Louis, issue Sep, pages 23-38.
  27. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, vol. 12(3), pages 383-398, September.
  28. Oberlechner, Thomas, 2001. "Importance of Technical and Fundamental Analysis in the European Foreign Exchange Market," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 6(1), pages 81-93, January.
  29. Lui, Yu-Hon & Mole, David, 1998. "The use of fundamental and technical analyses by foreign exchange dealers: Hong Kong evidence," Journal of International Money and Finance, Elsevier, vol. 17(3), pages 535-545, June.
Full references (including those not matched with items on IDEAS)

This item is not listed on Wikipedia, on a reading list or among the top items on IDEAS.

When requesting a correction, please mention this item's handle: RePEc:eme:jfeppp:v:1:y:2009:i:4:p:338-354. See general information about how to correct material in RePEc.

For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Virginia Chapman)

If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

If references are entirely missing, you can add them using this form.

If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.

If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.

Please note that corrections may take a couple of weeks to filter through the various RePEc services.

This information is provided to you by IDEAS at the Research Division of the Federal Reserve Bank of St. Louis using RePEc data.