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Taylor Rules and the Euro

  • Tanya Molodtsova
  • Alex Nikolsko-Rzhevskyy
  • David H. Papell

This paper uses real-time data to show that inflation and either the output gap or unemployment, the variables which normally enter central banks' Taylor rules for interest-rate-setting, can provide evidence of out-of-sample predictability and forecasting ability for the United States Dollar/Euro exchange rate from the inception of the Euro in 1999 to the end of 2007. We also present less formal evidence that, with real-time data, the Taylor rule provides a better description of ECB than of Fed policy during this period. The strongest evidence is found for specifications that neither incorporate interest rate smoothing nor include the real exchange rate in the forecasting regression, and the results are robust to whether or not the coefficients on inflation and the real economic activity measure are constrained to be the same for the U.S. and the Euro Area. The evidence is stronger with inflation forecasts than with inflation rates and with real-time data than with revised data. Bad news about inflation and good news about real economic activity both lead to out-of-sample predictability and forecasting ability through forecasted exchange rate appreciation.

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File URL: http://economics.emory.edu/home/assets/workingpapers/molodtsova_09_03_paper1.pdf
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Paper provided by Department of Economics, Emory University (Atlanta) in its series Emory Economics with number 0903.

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Date of creation: Feb 2009
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Handle: RePEc:emo:wp2003:0903
Contact details of provider: Web page: http://economics.emory.edu/home/journals/
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  1. Gourinchas, Pierre-Olivier & Tornell, Aaron, 2004. "Exchange rate puzzles and distorted beliefs," Journal of International Economics, Elsevier, vol. 64(2), pages 303-333, December.
  2. Francis X. Diebold & Robert S. Mariano, 1994. "Comparing Predictive Accuracy," NBER Technical Working Papers 0169, National Bureau of Economic Research, Inc.
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