Home bias, exchange rate disconnect, and optimal exchange rate policy

Jian Wang

No 701, Working Papers from Federal Reserve Bank of Dallas

Abstract: This paper examines how much the central bank should adjust the interest rate in response to real exchange rate fluctuations. The paper first demonstrates in a two-country Dynamic Stochastic General Equilibrium (DSGE) model, that the home bias in consumption is important to duplicate the exchange rate volatility and exchange rate disconnect documented in the data. When home bias is high, the shock to Uncovered Interest-rate Parity (UIP) can substantially drive up exchange rate volatility while leaving the volatility of real macroeconomic variables, such as GDP, almost untouched. The model predicts the volatility of the real exchange rate relative to that of GDP increases with the extent of home bias. This relation is strongly supported by the data. Then a second-order accurate solution method is employed to solve the model and compare the conditional welfare under different policy regimes. The results suggest that the monetary authority should not seek to vigorously stabilize exchange rate fluctuations. In particular, when the central bank does not take a strong stance against the inflation rate, exchange rate stabilization may induce substantial welfare loss. The model also suggests no welfare gain from the international monetary cooperation, which extends Obstfeld and Rogoff's (2002) findings to a DSGE model.

Pages: 35 pages
Date: 2007
New Economics Papers: this item is included in nep-cba, nep-dge and nep-ifn
Note: Published as: Wang, Jian (2010), "Home Bias, Exchange Rate Disconnect, and Optimal Exchange Rate Policy," Journal of International Money and Finance 29 (1): 55-78.
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Citations: View citations in EconPapers (3)

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Journal Article: Home bias, exchange rate disconnect, and optimal exchange rate policy (2010)
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