Learning monetary policy rules and real exchange rate dynamics
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Learning, Monetary Policy Rules, and Real Exchange Rate Dynamics. Nelson C. Mark University of Notre Dame. Fundamentals given a bad rap. Flood and Rose

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Learning monetary policy rules and real exchange rate dynamics

Learning, Monetary Policy Rules, and Real Exchange Rate Dynamics

Nelson C. Mark

University of Notre Dame


Fundamentals given a bad rap
Fundamentals given a bad rap Dynamics

  • Flood and Rose

    “When it comes to understanding exchange rate volatility, macroeconomics – “fundamentals” – is irrelevant, except in high inflation countries or in the long run. The large differences in exchange rate volatility across countries and time are simply mysterious from an aggregate perspective.”


Standard fundamentals
Standard Fundamentals Dynamics

  • Exchange rate fundamentals of old and many new macro models: m,m*,y,y*,c,c*

  • PPP fundamentals: a constant

    • Probable long-run connection

    • Tenuous short-run connections











Alternative macro fundamentals through the lens of taylor rules
Alternative macro fundamentals through the lens of Taylor-rules

  • Inflationary expectations

    • A rate of change

  • Output gap

    • Deviation from natural level


Real exchange rate and real interest differentials
Real exchange rate and real interest differentials Taylor-rules

  • Pricing equation is real interest parity: Expectations matter

  • Alternative strategies for modeling interest differential

  • Multivariate setting and monetary policy reaction functions contribute towards accurately modeling expectations of future interest rates


Model uncertainty and learning
Model uncertainty and learning Taylor-rules

  • Is this a credible framework for understanding real exchange rate dynamics?

  • Allow model uncertainty

    • Structural instability

      • Established FACT of life in international finance

      • Source of Meese-Rogoff’s failure to FIT out of sample


Model uncertainty and learning1
Model uncertainty and learning Taylor-rules

  • Public attempts to learn “true” values by recursive least squares

    • Coefficients of process that generates inflation, output gap, nominal interest rates

  • Ask if long swings could have been explained by historical fundamentals data

    • Real depreciation of late 70s, the “great appreciation” and subsequent “great depreciation”


Us germany interest rate reaction functions
US-GERMANY: Interest rate reaction functions Taylor-rules

  • The Fed:

  • The Bundesbank:


Us germany interest rate reaction functions1
US-GERMANY: Interest rate reaction functions Taylor-rules

  • Impose homogeneity


Us germany interest rate reaction functions2
US-GERMANY: Interest rate reaction functions Taylor-rules

  • GMM estimable differential form


The ree path inflation output gap differentials follow var p
The REE path: Inflation, output gap differentials follow VAR(p)

  • Forecasting: Companion form

  • Estimation



Ree solution
REE Solution VAR(p)


Learning path
Learning Path VAR(p)

Given

Generate

Given

Perceived

Law of

Motion



Update coefficients
Update coefficients VAR(p)

The VAR

Interest

Differential

Real

Exchange

Rate

Gain



Conclusions
Conclusions VAR(p)

  • Macro fundamentals approach not yet dead

    • Taylor rule fundamentals first cut.

    • Probably need to add a model of the risk premium


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