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The Real Exchange Rate in Open-Economy Taylor Rules: A Re-Assessment

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Abstract

This paper re-examines the merits of including an exchange rate response in Taylor-type interest rate rules for small open economies. Taylor (2001) and Taylor and Williams (2011) express what has been the conventional view: inclusion of the real exchange rate will either add little or might negatively affect the rule's performance. We argue that developments in the theory of optimal monetary policy for open economies taken together with increased instability in world financial markets warrant a re-examination of the issue. Examining three flexible inflation targeting strategies, we find that a small weight on real exchange rate stability in the loss function is sufficient to improve the performance of Taylor-type rules relative to optimal policy. Gains are substantial for domestic and REX inflation targets because a small weight on real exchange rate fluctuations inhibits the aggressive use of the policy instrument under optimal policy. As real exchange rate stability is a built-in feature of a CPI inflation objective, the gains under a CPI inflation target are considerably lower. A central bank that values real exchange rate stability and follows a Taylor-type rule should respond to the real exchange rate. Doing so reduces relative losses irrespective of the specification of the inflation objective. Only a complete disregard for exchange rate stability bears out the view that there is no substantive role for the real exchange rate in Taylor-type rules.

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  • Richard T. Froyen & Alfred V Guender, 2016. "The Real Exchange Rate in Open-Economy Taylor Rules: A Re-Assessment," Working Papers in Economics 16/10, University of Canterbury, Department of Economics and Finance.
  • Handle: RePEc:cbt:econwp:16/10
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    File URL: http://www.econ.canterbury.ac.nz/RePEc/cbt/econwp/1610.pdf
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    Cited by:

    1. Chen, Chuanglian & Yao, Shujie & Ou, Jinghua, 2017. "Exchange rate dynamics in a Taylor rule framework," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 46(C), pages 158-173.
    2. repec:eee:ecmode:v:73:y:2018:i:c:p:140-151 is not listed on IDEAS

    More about this item

    Keywords

    CPI; Domestic; REX Inflation Targeting; Taylor-Type Rules; Timeless Perspective; Real Exchange Rate;

    JEL classification:

    • E3 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles
    • E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit
    • F3 - International Economics - - International Finance

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