Learning, Monetary Policy Rules, and Real Exchange Rate Dynamics - PowerPoint PPT Presentation

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Learning, Monetary Policy Rules, and Real Exchange Rate Dynamics

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Inflation differentials, real dollar-yen rate. Inflation differentials, real dollar-CD rate ... that generates inflation, output gap, nominal interest rates ... – PowerPoint PPT presentation

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Title: Learning, Monetary Policy Rules, and Real Exchange Rate Dynamics


1
Learning, Monetary Policy Rules, and Real
Exchange Rate Dynamics
  • Nelson C. Mark
  • University of Notre Dame

2
Fundamentals given a bad rap
  • 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.

3
Standard Fundamentals
  • 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

4
Traditional Fundamentals
5
Traditional Fundamentals
6
Monetary Fundamentals
7
Inflation differentials, real dollar-DM rate
8
Inflation differentials, real dollar-DM rate
9
Inflation differentials, real dollar-DM rate
10
Inflation differentials, real -pound rate
11
Inflation differentials, real dollar-yen rate
12
Inflation differentials, real dollar-CD rate
13
Alternative macro fundamentals through the lens
of Taylor-rules
  • Inflationary expectations
  • A rate of change
  • Output gap
  • Deviation from natural level

14
Real exchange rate and real interest differentials
  • 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

15
Model uncertainty and learning
  • 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-Rogoffs failure to FIT out of
    sample

16
Model uncertainty and learning
  • 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

17
US-GERMANY Interest rate reaction functions
  • The Fed
  • The Bundesbank

18
US-GERMANY Interest rate reaction functions
  • Impose homogeneity

19
US-GERMANY Interest rate reaction functions
  • GMM estimable differential form

20
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21
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22
The REE path Inflation, output gap differentials
follow VAR(p)
  • Forecasting Companion form
  • Estimation

23
The REE path Pricing by real interest parity
24
REE Solution
25
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26
Learning Path
Given
Generate
Given
Perceived Law of Motion
27
Actual Law of Motion
28
Update coefficients
The VAR
Interest Differential
Real Exchange Rate
Gain
29
Alternative gain specifications
30
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31
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33
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35
Conclusions
  • 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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