Academic journal article Journal of Money, Credit & Banking

Taylor Rules and the Deutschmark-Dollar Real Exchange Rate

Academic journal article Journal of Money, Credit & Banking

Taylor Rules and the Deutschmark-Dollar Real Exchange Rate

Article excerpt

THIS PAPER EXPLORES the link between an interest rate rule for monetary policy and the behavior of the real exchange rate.

A large body of research has studied the connection between monetary policy or interest rates on the one hand and exchange rates on the other. The vintage monetary model of the exchange rate takes the money supply as the indicator of policy. (See Frankel and Rose, 1995, for a survey.) Some recent literature (Bergin 2003) also assumes exogenous monetary policy, while estimating a general equilibrium sticky-price open-economy macroeconomic model. Yet an ongoing literature has argued, persuasively in our view, that recent monetary policy can be better modeled as taking the interest rate as the instrument of policy, with policy described by a feedback rule. The empirical literature for the United States includes Taylor (1993) as a relatively early contribution, English, Nelson, and Sack (2003) as a recent study. Open-economy interest rate rules that include exchange rates have been studied quantitatively (e.g., Clarida, Gali, and Gertler, 1998, Meredith and Ma, 2002) and in terms of welfare properties (e.g., Ball, 1999, Clarida, Gali, and Gertler, 2001, Svensson, 2000, and Kollman, 2002). These papers do not, however, consider the positive effects of interest rate rules on the exchange rate.

At least four strands of literature do specifically analyze real or nominal exchange rates in a framework that treats the interest rate-exchange rate interaction in detail. One is the literature on identified VARs. Kim (2002), who includes an exchange rate in his interest rate equation, is an example. A second strand of the literature tests or examines interest parity, in a relatively unstructured way, decomposing real exchange rate movements into components that can be linked to interest rates and those that cannot. Examples include Campbell and Clarida (1987), Edison and Pauls (1993), and Baxter (1994). A third strand of the literature develops general equilibrium sticky-price models, and uses calibration. Examples include Benigno (1999) and Benigno and Benigno (2001). The papers in these three strands typically, though not always, find a statistically or quantitatively strong connection between interest rates and exchange rates. This encourages us to study the connection. We use an approach that is shared by a fourth strand of the literature.

This strand is a long-standing one that models the exchange rate as a present value. Traditional econometric techniques are used, and the present value is estimated using atheoretical forecasting equations. Examples include Woo (1985), Frankel and Meese (1987), and West (1987). In terms of mechanics, our empirical approach is similar to that of the present value literature, though this literature has yet to consider Taylor rules.

Several of the papers cited above have added terms in exchange rates to otherwise standard Taylor rules (e.g., Clarida, Gali, and Gertler, 1998, Benigno, 1999). We, too, take this approach, adding the deviation of the real exchange rate from its steady state value to a Taylor rule that also includes standard terms in inflation and output. We do so with the aim of evaluating the effect such a term has on time series properties of aggregate variables, including in particular exchange rates. We show that in conjunction with interest parity, this modified rule delivers a relation between current and expected real exchange rates on the one hand and inflation and output on the other.

Our empirical work solves this relationship forward, expressing the real exchange rate as the present value of the difference between home and foreign output gaps and inflation rates. The discount factor depends on the weight that the real exchange rate receives in the Taylor rule. The weights on output and inflation are those of the Taylor rule. We attempt to gauge the congruence between the variable implied by this present value and the actual Deutschmark-dollar real exchange rate, 1979-98. …

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