TAYLOR RULE REACTION COEFFICIENTS AND REAL EXCHANGE RATE PERSISTENCE

Bernd Kempa

Bulletin of Economic Research, 2018, vol. 70, issue 1, 64-73

Abstract: Recent literature has established a link between the persistence of real exchange rates and the degree of inertia in Taylor rule monetary policy reactions functions. This paper provides a different view on this link by investigating how the size of Taylor rule reaction coefficients impacts the adjustment dynamics of the real exchange rate. Within a stylized sticky†price open†economy macro model, it is demonstrated that a stronger interest rate reaction to inflation in the Taylor rule raises the convergence speed of the real exchange rate. Conversely, raising the coefficient on the output gap or attending to the exchange rate in an open†economy version of the Taylor rule slows down real exchange rate adjustment. In all cases, more rapid convergence comes at the cost of stronger initial real exchange rate misalignments in the wake of monetary policy shocks.

Date: 2018
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