Trend inflation and exchange rate dynamics: A New Keynesian approach

Takashi Kano

CAMA Working Papers from Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University

Abstract: The paper studies exchange rate implications of trend inflation within a two-country New Keynesian (NK) model under incomplete international financial markets. A NK Phillips curve generalized by trend inflation with a positive long-run mean implies an expectational difference equation of inflation with higher-order leads of expected inflation. The resulting two-country inflation differential is smoother, more persistent, and more insensitive to a real exchange rate. General equilibrium then yields (i) a persistent real exchange rate with an autoregressive root close to one, (ii) a hump-shaped impulse response of a real exchange rate with a half-life longer than four years, (iii) a volatile real exchange rate relative to cross-country inflation differential, (iv) an almost perfect co-movement between real and nominal exchange rates and (v) a sharp rise in the volatility of a real exchange rate from a managed nominal exchange rate regime to a flexible one within an otherwise standard two-country NK model. Trend inflation, therefore, approaches empirical puzzles of exchange rates dynamics.

Keywords: Real and Nominal Exchange Rates; Trend Inflation; New Keynesian Models (search for similar items in EconPapers)
JEL-codes: E31 E52 F31 F41 (search for similar items in EconPapers)
Pages: 38 pages
Date: 2016-12
New Economics Papers: this item is included in nep-cba, nep-dge, nep-mac, nep-mon and nep-opm
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Citations: View citations in EconPapers (2)

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Related works:
Journal Article: Trend inflation and exchange rate dynamics: A new Keynesian approach (2024)
Working Paper: Trend Inflation and Exchange Rate Dynamics: A New Keynesian Approach (2021)
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Persistent link: https://EconPapers.repec.org/RePEc:een:camaaa:2016-74

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