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Exchange rate and price dynamics in a small open economy - the role of the zero lower bound and monetary policy regimes

Gregor Bäurle and Daniel Kaufmann ()
Authors registered in the RePEc Author Service: Gregor Bäurle ()

No 2014-10, Working Papers from Swiss National Bank

Abstract: We analyse nominal exchange rate and price dynamics after risk premium shocks with short-term interest rates constrained by the zero lower bound (ZLB). In a small-open-economy DSGE model, temporary risk premium shocks lead to shifts of the exchange rate and the price level if a central bank implements an inflation target by means of a traditional Taylor rule. These shifts are strongly amplified and become more persistent once the ZLB is included in the model. We also provide empirical support for this finding. Using a Bayesian VAR for Switzerland, we find that responses of the exchange rate and the price level to a temporary risk premium shock are larger and more persistent when the ZLB is binding. Our theoretical discussion shows that alternative monetary policy rules that stabilise price-level expectations are able to dampen exchange rate and price fluctuations when the ZLB is binding. This stabilisation can be achieved by including either the price level or, alternatively, the nominal exchange rate in the policy rule.

Keywords: Exchange rate and price dynamics; zero lower bound on short-term interest rates; small-open-economy DSGE model; monetary policy regimes; monetary transmission; Bayesian VAR; sign restrictions (search for similar items in EconPapers)
JEL-codes: C11 C32 E31 E37 E52 E58 F31 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cba, nep-dge, nep-mac, nep-mon and nep-opm
Date: 2014
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (12) Track citations by RSS feed

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