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Is Bad News About Inflation Good News for the Exchange Rate?

  • Richard Clarida
  • Daniel Waldman

We show in a simple -- but robust -- theoretical monetary exchange rate model that the sign of the covariance between an inflation surprise and the nominal exchange rate can tell us something about how monetary policy is conducted. Specifically, we show that 'bad news' about inflation -- that it is higher than expected -- can be 'good news' for the nominal exchange rate -- that it appreciates on this news -- if the central bank has an inflation target that it implements with a Taylor Rule. The empirical work in this paper examines point sampled data on inflation announcements and the reaction of nominal exchange rates in 10 minute windows around these announcements for 10 countries and several different inflation measures for the period July 2001 through March 2005. When we pool the data, we do in fact find that bad news about inflation is indeed good news for the nominal exchange rate, that the results are statistically significant, and that the r-square is substantial, in excess of 0.25 for core measures of inflation. We also find significant differences comparing the inflation targeting countries and the two non-inflation targeting countries.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 13010.

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Date of creation: Apr 2007
Date of revision:
Publication status: published as Campbell, John (ed.) Asset Prices and Monetary Policy. Chicago: University of Chicago Press, 2009.
Handle: RePEc:nbr:nberwo:13010
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  1. Richard Clarida & Jordi Gali & Mark Gertler, 1997. "Monetary Policy Rules in Practice: Some International Evidence," NBER Working Papers 6254, National Bureau of Economic Research, Inc.
  2. Mussa, Michael, 1982. "A Model of Exchange Rate Dynamics," Journal of Political Economy, University of Chicago Press, vol. 90(1), pages 74-104, February.
  3. Laurence Ball, 1998. "Policy Rules for Open Economies," NBER Working Papers 6760, National Bureau of Economic Research, Inc.
  4. Campbell, John & Clarida, Richard, 1987. "The Dollar and Real Interest Rates," Scholarly Articles 3221495, Harvard University Department of Economics.
  5. Svensson, Lars E.O., 1998. "Open-Economy Inflation Targeting," Seminar Papers 638, Stockholm University, Institute for International Economic Studies.
  6. Dale W. Henderson & Warwick J. McKibbin, 1993. "A comparison of some basic monetary policy regimes for open economies: implications of different degrees of instrument adjustment and wage persistence," International Finance Discussion Papers 458, Board of Governors of the Federal Reserve System (U.S.).
  7. Jon Faust & John H. Rogers & Shing-Yi Wang & Jonathan H. Wright, 2003. "The high-frequency response of exchange rates and interest rates to macroeconomic announcements," International Finance Discussion Papers 784, Board of Governors of the Federal Reserve System (U.S.).
  8. 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.
  9. Torben G. Andersen & Tim Bollerslev & Francis X. Diebold & Clara Vega, 2002. "Micro Effects of Macro Announcements: Real-Time Price Discovery in Foreign Exchange?," Center for Financial Institutions Working Papers 02-23, Wharton School Center for Financial Institutions, University of Pennsylvania.
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