IDEAS home Printed from https://ideas.repec.org/
MyIDEAS: Log in (now much improved!) to save this paper

Exchange Rate Dynamics under Alternative Optimal Interest Rate Rules

  • Mahir Binici
  • Yin-Wong Cheung

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.

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: http://www.cesifo-group.de/portal/page/portal/DocBase_Content/WP/WP-CESifo_Working_Papers/wp-cesifo-2011/wp-cesifo-2011-09/cesifo1_wp3577.pdf
Download Restriction: no

Paper provided by CESifo Group Munich in its series CESifo Working Paper Series with number 3577.

as
in new window

Length:
Date of creation: 2011
Date of revision:
Handle: RePEc:ces:ceswps:_3577
Contact details of provider: Postal:
Poschingerstrasse 5, 81679 Munich

Phone: +49 (89) 9224-0
Fax: +49 (89) 985369
Web page: http://www.cesifo-group.de
Email:


More information through EDIRC

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. McCallum, Bennett T., 1994. "Specification of policy rules and performance measures in multicountry simulation studies," Journal of International Money and Finance, Elsevier, vol. 13(3), pages 259-275, June.
  2. 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.
  3. Woodford, M., 1999. "Optimal Monetary Policy Inertia.," Papers 666, Stockholm - International Economic Studies.
  4. Cheung, Yin-Wong & Chinn, Menzie David & Garcia Pascual, Antonio, 2003. "Empirical Exchange Rate Models of the Nineties: Are Any Fit to Survive?," Santa Cruz Department of Economics, Working Paper Series qt12z9x4c5, Department of Economics, UC Santa Cruz.
  5. Svensson, L.E.O., 1998. "Inflation Targeting as a Monetary Policy Rule," Papers 646, Stockholm - International Economic Studies.
  6. Engel, Charles, 1996. "The forward discount anomaly and the risk premium: A survey of recent evidence," Journal of Empirical Finance, Elsevier, vol. 3(2), pages 123-192, June.
  7. Söderlind, Paul & Söderström, Ulf & Vredin, Anders, 2003. "Taylor Rules and the Predictability of Interest Rates," Working Paper Series 147, Sveriges Riksbank (Central Bank of Sweden).
  8. Marc P. Giannoni & Michael Woodford, 2003. "Optimal Interest-Rate Rules: II. Applications," NBER Working Papers 9420, National Bureau of Economic Research, Inc.
  9. Nicoletta Batini & Richard Harrison & Stephen P. Millard, 2001. "Monetary policy rules for an open economy," Proceedings, Federal Reserve Bank of San Francisco, issue Mar.
  10. John H. Cochrane, 2011. "Determinacy and Identification with Taylor Rules," Journal of Political Economy, University of Chicago Press, vol. 119(3), pages 565 - 615.
  11. Nelson C. Mark, 2005. "Changing Monetary Policy Rules, Learning, and Real Exchange Rate Dynamics," NBER Working Papers 11061, National Bureau of Economic Research, Inc.
  12. Frederic S. Mishkin, 2004. "Can Inflation Targeting Work in Emerging Market Countries?," NBER Working Papers 10646, National Bureau of Economic Research, Inc.
  13. Charles Engel & Nelson C. Mark & Kenneth D. West, 2007. "Exchange Rate Models Are Not as Bad as You Think," NBER Working Papers 13318, National Bureau of Economic Research, Inc.
  14. Ben S. Bernanke & Michael Woodford, 1997. "Inflation forecasts and monetary policy," Proceedings, Federal Reserve Bank of Cleveland, pages 653-686.
  15. Lars E. O. Svensson, 2003. "What is Wrong with Taylor Rules? Using Judgment in Monetary Policy through Targeting Rules," NBER Working Papers 9421, National Bureau of Economic Research, Inc.
  16. Wang, Jian & Wu, Jason J., 2008. "The Taylor rule and forecast intervals for exchange rates," Globalization and Monetary Policy Institute Working Paper 22, Federal Reserve Bank of Dallas.
  17. Rudebusch, Glenn D., 2002. "Term structure evidence on interest rate smoothing and monetary policy inertia," Journal of Monetary Economics, Elsevier, vol. 49(6), pages 1161-1187, September.
  18. S Derlind, Paul & S Derstr M, Ulf & Vredin, Anders, 2005. "Dynamic Taylor Rules And The Predictability Of Interest Rates," Macroeconomic Dynamics, Cambridge University Press, vol. 9(03), pages 412-428, June.
  19. Meese, Richard A. & Rogoff, Kenneth, 1983. "Empirical exchange rate models of the seventies : Do they fit out of sample?," Journal of International Economics, Elsevier, vol. 14(1-2), pages 3-24, February.
  20. Leitemo, Kai & Söderström, Ulf, 2001. "Simple Monetary Policy Rules and Exchange Rate Uncertainty," Working Paper Series 122, Sveriges Riksbank (Central Bank of Sweden).
  21. Inoue, Atsushi & Kilian, Lutz, 2002. "In-Sample or Out-of-Sample Tests of Predictability: Which One Should We Use?," CEPR Discussion Papers 3671, C.E.P.R. Discussion Papers.
  22. Diebold, Francis X & Mariano, Roberto S, 2002. "Comparing Predictive Accuracy," Journal of Business & Economic Statistics, American Statistical Association, vol. 20(1), pages 134-44, January.
  23. Bennett T. McCallum, 2008. "Inflation Determination with Taylor Rules: Is New Keynesian Analysis Critically Flawed?," NBER Working Papers 14534, National Bureau of Economic Research, Inc.
  24. Chinn, Menzie D. & Meese, Richard A., 1995. "Banking on currency forecasts: How predictable is change in money?," Journal of International Economics, Elsevier, vol. 38(1-2), pages 161-178, February.
  25. Kenneth S. Rogoff & Vania Stavrakeva, 2008. "The Continuing Puzzle of Short Horizon Exchange Rate Forecasting," NBER Working Papers 14071, National Bureau of Economic Research, Inc.
  26. Molodtsova, Tanya & Nikolsko-Rzhevskyy, Alex & Papell, David H., 2008. "Taylor rules with real-time data: A tale of two countries and one exchange rate," Journal of Monetary Economics, Elsevier, vol. 55(Supplemen), pages S63-S79, October.
  27. George W. Evans & Seppo Honkapohja, 2004. "Friedman’s money supply rule vs optimal interest rate policy," Macroeconomics 0405002, EconWPA.
  28. John B. Taylor & John C. Williams, 2010. "Simple and robust rules for monetary policy," Working Paper Series 2010-10, Federal Reserve Bank of San Francisco.
  29. Evans, Martin D. & Lyons, Richard K., 1999. "Order Flow and Exchange Rate Dynamics," Research Program in Finance, Working Paper Series qt0dh1c16w, Research Program in Finance, Institute for Business and Economic Research, UC Berkeley.
  30. John B. Taylor, 2001. "The Role of the Exchange Rate in Monetary-Policy Rules," American Economic Review, American Economic Association, vol. 91(2), pages 263-267, May.
  31. Andrew K. Rose, 2006. "A Stable International Monetary System Emerges: Inflation Targeting is Bretton Woods, Reversed," NBER Working Papers 12711, National Bureau of Economic Research, Inc.
  32. Frankel, Jeffrey A. & Rose, Andrew K., 1995. "Empirical research on nominal exchange rates," Handbook of International Economics, in: G. M. Grossman & K. Rogoff (ed.), Handbook of International Economics, edition 1, volume 3, chapter 33, pages 1689-1729 Elsevier.
  33. Bennett T. McCallum & Edward Nelson, . "Performance of Operational Policy Rules in an Estimated Semi-Classical Structural Model," GSIA Working Papers 1998-22, Carnegie Mellon University, Tepper School of Business.
  34. Carl E. Walsh, 2003. "Monetary Theory and Policy, 2nd Edition," MIT Press Books, The MIT Press, edition 2, volume 1, number 0262232316.
  35. Michael Woodford, 2001. "The Taylor Rule and Optimal Monetary Policy," American Economic Review, American Economic Association, vol. 91(2), pages 232-237, May.
  36. Emi Nakamura & Jón Steinsson, 2008. "Five Facts about Prices: A Reevaluation of Menu Cost Models," The Quarterly Journal of Economics, Oxford University Press, vol. 123(4), pages 1415-1464.
  37. Jeffrey A. Frankel and Andrew K. Rose., 1995. "A Survey of Empirical Research on Nominal Exchange Rates," Center for International and Development Economics Research (CIDER) Working Papers C95-051, University of California at Berkeley.
  38. John B. Taylor, 1999. "A Historical Analysis of Monetary Policy Rules," NBER Chapters, in: Monetary Policy Rules, pages 319-348 National Bureau of Economic Research, Inc.
  39. 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.
  40. Brian P. Sack & Volker W. Wieland, 1999. "Interest-rate smoothing and optimal monetary policy: a review of recent empirical evidence," Finance and Economics Discussion Series 1999-39, Board of Governors of the Federal Reserve System (U.S.).
  41. Hall, Simon & Walsh, Mark & Yates, Anthony, 2000. "Are UK Companies' Prices Sticky?," Oxford Economic Papers, Oxford University Press, vol. 52(3), pages 425-46, July.
  42. Clarida, Richard & Galí, Jordi & Gertler, Mark, 2002. "A Simple Framework for International Monetary Policy Analysis," CEPR Discussion Papers 3355, C.E.P.R. Discussion Papers.
  43. Richard H. Clarida & Jordi Gali & Mark Gertler, 1998. "Monetary policy rules in practice," Proceedings, Federal Reserve Bank of San Francisco, issue Mar.
  44. Svensson, L-E-O, 1996. "Inflation Forecast Targeting : Implementaing and Monitoring Inflation Targets," Papers 615, Stockholm - International Economic Studies.
  45. Carl E. Walsh, 2009. "Inflation Targeting: What Have We Learned?," International Finance, Wiley Blackwell, vol. 12(2), pages 195-233, 08.
  46. Molodtsova, Tanya & Papell, David H., 2009. "Out-of-sample exchange rate predictability with Taylor rule fundamentals," Journal of International Economics, Elsevier, vol. 77(2), pages 167-180, April.
  47. Philippe Bacchetta & Eric van Wincoop, 2010. "Infrequent Portfolio Decisions: A Solution to the Forward Discount Puzzle," American Economic Review, American Economic Association, vol. 100(3), pages 870-904, June.
  48. Marc Giannoni & Michael Woodford, 2003. "How forward-looking is optimal monetary policy?," Proceedings, Federal Reserve Bank of Cleveland, pages 1425-1483.
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:ces:ceswps:_3577. 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: (Klaus Wohlrabe)

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.