Money Supply Rules and Exchange Rate Dynamics

Juha Tervala

International Economic Journal, 2012, vol. 26, issue 4, 547-565

Abstract: This paper examines the implications of monetary policy rules for exchange rate dynamics. I extend a standard New Open Economy Macroeconomics model with the introduction of a simple money supply rule, whereby central banks change their monetary policy if output diverges from potential output or if inflation diverges from the target inflation. A key result is that, in the case of permanent technology and monetary shocks, the nominal exchange rate does not follow a random walk; instead, the exchange rate undershoots its long-run value. An undershooting of the exchange rate derives from the active monetary policy that both countries conduct.

Date: 2012
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DOI: 10.1080/10168737.2011.558517

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