Changing Monetary Policy Rules, Learning, and Real Exchange Rate Dynamics

Nelson Mark

No 11061, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: When central banks set nominal interest rates according to an interest rate reaction function, such as the Taylor rule, and the exchange rate is priced by uncovered interest parity, the real exchange rate is determined by expected inflation differentials and output gap differentials. In this paper I examine the implications of these Taylor-rule fundamentals for real exchange rate determination in an environment where market participants are ignorant of the numerical values of the model's coefficients but attempt to acquire that information using least-squares learning rules. I find evidence that this simple learning environment provides a plausible framework for understanding real dollar--DM exchange rate dynamics from 1976 to 2003. The least-squares learning path for the real exchange rate implied by inflation and output gap data exhibits the real depreciation of the 70s, the great appreciation (1979.4-1985.1) and the subsequent great depreciation (1985.2-1991.1) observed in the data. An emphasis on Taylor-rule fundamentals may provide a resolution to the exchange rate disconnect puzzle.

JEL-codes: F4 (search for similar items in EconPapers)
Date: 2005-01
New Economics Papers: this item is included in nep-cba, nep-ifn and nep-mon
Note: IFM ME
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (21)

Published as Nelson C. Mark, 2009. "Changing Monetary Policy Rules, Learning, and Real Exchange Rate Dynamics," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 41(6), pages 1047-1070, 09.

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