The Complex Response of Monetary Policy to the Exchange Rate

Ram Kharel, Christopher Martin and Costas Milas
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Ram Kharel: Brunel University

No KERP 2006/17, Keele Economics Research Papers from Centre for Economic Research, Keele University

Abstract: 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.

Keywords: Monetary policy; asset prices; nonlinearity (search for similar items in EconPapers)
JEL-codes: C51 C52 E52 E58 (search for similar items in EconPapers)
Pages: 24 pages
Date: 2006-09
New Economics Papers: this item is included in nep-cba, nep-mac and nep-mon
Note: We thank Kevin Lee and Roberto Gonzalez for useful comments and suggestions.
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Related works:
Journal Article: THE COMPLEX RESPONSE OF MONETARY POLICY TO THE EXCHANGE RATE (2010)
Working Paper: The Complex Response of Monetary Policy to the Exchange Rate (2007)
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