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When the Bubble Bursts: Monetary Policy Rules and Foreign Exchange Market Behavior

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  • Batini, Nicoletta
  • Nelson, Edward

Abstract

We examine the effects of a “bubble” in the foreign exchange market, defined as an exogenous process that temporarily shifts the exchange rate away from the value implied by fundamentals. The bubble process is analogous to Bernanke and Gertler’s (1999) specification of an asset price bubble. We evaluate the performance of alternative simple monetary policy rules under both bubble and no-bubble scenarios and investigate whether policymakers should react to the deviation of the exchange rate from its steady-state value. The policy experiments employ a small-scale forward-looking structural model calibrated to UK data, which we previously used in Batini and Nelson (2000). For this model, which includes an uncovered interest parity condition, we find that the appropriate response to the exchange rate is captured by the expected inflation term, provided that the response coefficient and the inflation horizon are optimized. When uncovered interest parity is relaxed, there appears to be more merit in incorporating a separate exchange rate term in the monetary policy rule.

Suggested Citation

  • Batini, Nicoletta & Nelson, Edward, 2000. "When the Bubble Bursts: Monetary Policy Rules and Foreign Exchange Market Behavior," Working Papers 2000-01, University of Sydney, School of Economics.
    • Handle: RePEc:syd:wpaper:2000-01
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    1. McCallum, Bennett T. & Nelson, Edward, 1999. "Nominal income targeting in an open-economy optimizing model," Journal of Monetary Economics, Elsevier, vol. 43(3), pages 553-578, June.
    2. Fuhrer, Jeffrey C, 1997. "The (Un)Importance of Forward-Looking Behavior in Price Specifications," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 29(3), pages 338-350, August.
    3. Paul R. Bergin & Robert C. Feenstra, 2017. "Pricing-to-Market, Staggered Contracts, and Real Exchange Rate Persistence," World Scientific Book Chapters,in: International Macroeconomic Interdependence, chapter 6, pages 155-185 World Scientific Publishing Co. Pte. Ltd..
    4. McCallum, Bennett T., 1994. "A reconsideration of the uncovered interest parity relationship," Journal of Monetary Economics, Elsevier, vol. 33(1), pages 105-132, February.
    5. Nicoletta Batini & Andrew Haldane, 1999. "Forward-Looking Rules for Monetary Policy," NBER Chapters,in: Monetary Policy Rules, pages 157-202 National Bureau of Economic Research, Inc.
    6. Wu, Yangru, 1995. "Are there rational bubbles in foreign exchange markets? Evidence from an alternative test," Journal of International Money and Finance, Elsevier, vol. 14(1), pages 27-46, February.
    7. McCallum, Bennett T., 1983. "On non-uniqueness in rational expectations models : An attempt at perspective," Journal of Monetary Economics, Elsevier, vol. 11(2), pages 139-168.
    8. Adrian Blundell-Wignall, 1993. "Introduction to The Exchange Rate, International Trade and the Balance of Payments," RBA Annual Conference Volume,in: Adrian Blundell-Wignall (ed.), The Exchange Rate, International Trade and the Balance of Payments Reserve Bank of Australia.
    9. Charemza, Wojciech W., 1996. "Detecting stochastic bubbles on an East European foreign exchange market: An estimation/simulation approach," Structural Change and Economic Dynamics, Elsevier, vol. 7(1), pages 35-53, March.
    10. Evans, George W, 1986. "A Test for Speculative Bubbles in the Sterling-Dollar Exchange Rate: 1981-84," American Economic Review, American Economic Association, vol. 76(4), pages 621-636, September.
    11. Nicoletta Batini & Kenny Turnbull, 2000. "Monetary Conditions Indices for the UK: A Survey," Discussion Papers 01, Monetary Policy Committee Unit, Bank of England.
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