Monetarist Monetary Policy, Exchange Risk, and Exchange Rate Variability

David Papell

No 1306, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: This paper investigates the relationship between the new monetary control procedures, implemented by the Federal Reserve Board in October 1979, and the subsequent increase in exchange rate variability for the United States. It shows that, in the context of a stochastic, rational expectations model,exchange rate variability minimizing monetary policy is identical to the policy which, in a deterministic, perfect foresight model, would place the economy on the borderline between exchange rate overshooting and undershooting. The model is estimated for the United States since generalized floating began in 1973. The new monetary control procedures have had two opposite effects. Monetary policy has become less accommodative, increasing exchange rate variability through overshooting. On the other hand ,systematic deviations from uncovered interest rate parity, which can be attributed to exchange risk, have also increased. These increase exchange rate variability through undershooting. It is shown that the latter dominate the former, providing an explanation of increased exchange rate variability consistent with undershooting, not with overshooting.

Date: 1984-03
Note: ITI IFM
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