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The Complex Response of Monetary Policy to the Exchange Rate

  • Ram Sharan Kharel

    (Brunel University)

  • Christopher Martin

    (Brunel University)

  • Costas Milas

    ()

    (Keele University, Centre for Economic Research and School of Economic and Management Studies)

We estimate a flexible non-linear monetary policy rule for the UK to examine the response of policymakers to the real exchange rate. We have three main findings. First, policymakers respond to real exchange rate misalignment rather than to the real exchange rate itself. Second, policymakers ignore small deviations of the exchange rate; they only respond to real exchange under-valuations of more than 4\% and over-valuations of more than 5\%. Third, the response of policymakers to inflation is smaller when the exchange rate is over-valued and larger when it is under-valued. None of these responses is allowed for in the widely-used Taylor rule, suggesting that monetary policy is better analysed using a more sophisticated model, such as the one suggested in this paper.

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Paper provided by Centre for Economic Research, Keele University in its series Keele Economics Research Papers with number KERP 2006/17.

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Length: 24 pages
Date of creation: Sep 2006
Date of revision:
Handle: RePEc:kee:kerpuk:2006/17
Note: We thank Kevin Lee and Roberto Gonzalez for useful comments and suggestions.
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Phone: +44 (0)1782 584581
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Order Information: Postal: Centre for Economic Research, Research Institute for Public Policy and Management, Keele University, Staffordshire ST5 5BG - United Kingdom
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  1. Martin, Christopher & Costas Milas, 2002. "Modelling Monetary Policy: Inflation Targeting in Practice," Royal Economic Society Annual Conference 2002 137, Royal Economic Society.
  2. Chadha, Jagjit S & Sarno, Lucio & Valente, Giorgio, 2003. "Monetary Policy Rules, Asset Prices and Exchange Rates," CEPR Discussion Papers 4114, C.E.P.R. Discussion Papers.
  3. Mehtap Kesriyeli & Denise R. Osborn & Marianne Sensier, 2004. "Nonlinearity and Structural Change in Interest Rate Reaction Functions for the US, UK and Germany," Working Papers 0414, Research and Monetary Policy Department, Central Bank of the Republic of Turkey.
  4. Engel, Charles & West, Kenneth D., 2006. "Taylor Rules and the Deutschmark: Dollar Real Exchange Rate," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 38(5), pages 1175-1194, August.
  5. Alexander Mihailov, 2007. "Does Instrument Independence Matter under the Constrained Discretionof an Inflation Targeting Goal? Lessons from UK Taylor Rule Empirics," Money Macro and Finance (MMF) Research Group Conference 2006 95, Money Macro and Finance Research Group.
  6. Christopher Adam & David Cobham & Eric Girardin, 2005. "Monetary Frameworks and Institutional Constraints: UK Monetary Policy Reaction Functions, 1985-2003," Oxford Bulletin of Economics and Statistics, Department of Economics, University of Oxford, vol. 67(4), pages 497-516, 08.
  7. Jansen, Eilev S. & Teräsvirta, Timo, 1995. "Testing Parameter Constancy and super Exogeneity in Econometric Equations," SSE/EFI Working Paper Series in Economics and Finance 53, Stockholm School of Economics.
  8. Dick van Dijk & Timo Terasvirta & Philip Hans Franses, 2002. "Smooth Transition Autoregressive Models — A Survey Of Recent Developments," Econometric Reviews, Taylor & Francis Journals, vol. 21(1), pages 1-47.
  9. David Cobham, 2006. "The Overvaluation of Sterling Since 1996: How the Policy makers Responded and Why," Economic Journal, Royal Economic Society, vol. 116(512), pages F185-F207, 06.
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