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Exchange rate and price dynamics in a small open economy - the role of the zero lower bound and monetary policy regimes

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Listed author(s):
  • Gregor Bäurle
  • Daniel Kaufmann

Abstract

We analyse nominal exchange rate and price dynamics after risk premium shocks with short-term interest rates constrained by the zero lower bound (ZLB). In a small-open-economy DSGE model, temporary risk premium shocks lead to shifts of the exchange rate and the price level if a central bank implements an inflation target by means of a traditional Taylor rule. These shifts are strongly amplified and become more persistent once the ZLB is included in the model. We also provide empirical support for this finding. Using a Bayesian VAR for Switzerland, we find that responses of the exchange rate and the price level to a temporary risk premium shock are larger and more persistent when the ZLB is binding. Our theoretical discussion shows that alternative monetary policy rules that stabilise price-level expectations are able to dampen exchange rate and price fluctuations when the ZLB is binding. This stabilisation can be achieved by including either the price level or, alternatively, the nominal exchange rate in the policy rule.

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Paper provided by Swiss National Bank in its series Working Papers with number 2014-10.

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Length: 41 pages
Date of creation: 2014
Handle: RePEc:snb:snbwpa:2014-10
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Keywords: Exchange rate and price dynamics; zero lower bound on short-term interest rates; small-open-economy DSGE model; monetary policy regimes; monetary transmission; Bayesian VAR; sign restrictions;

Find related papers by JEL classification:

  • C11 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Bayesian Analysis: General
  • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models
  • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
  • E37 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Forecasting and Simulation: Models and Applications
  • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
  • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
  • F31 - International Economics - - International Finance - - - Foreign Exchange

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Cited by:

  1. Roberta Cardani & Alessia Paccagnini & Stelios D. Bekiros, 2017. "The Effectiveness of Forward Guidance in an Estimated DSGE Model for the Euro Area: the Role of Expectations," Working Papers 201701, School of Economics, University College Dublin.
  2. Florian Huber & Daniel Kaufmann, 2015. "Trend Fundamentals and Exchange Rate Dynamics," KOF Working papers 15-393, KOF Swiss Economic Institute, ETH Zurich.
  3. Gregor Bäurle & Daniel Kaufmann & Sylvia Kaufmann & Rodney W. Strachan, 2016. "Changing dynamics at the zero lower bound," Working Papers 2016-16, Swiss National Bank.
  4. Michal Brzoza-Brzezina & Marcin Kolasa & Mateusz Szetela, 2016. "Is Poland at risk of the zero lower bound?," Bank i Kredyt, Narodowy Bank Polski, vol. 47(3), pages 195-226.
  5. Gregor Bäurle & Elizabeth Steiner, 2015. "How do Individual Sectors Respond to Macroeconomic Shocks? A Structural Dynamic Factor Approach Applied to Swiss Data," Swiss Journal of Economics and Statistics (SJES), Swiss Society of Economics and Statistics (SSES), vol. 151(III), pages 167-225, September.

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