Exchange rate dynamics under alternative optimal interest rate rules

Research output: Journal Publications and Reviews (RGC: 21, 22, 62)21_Publication in refereed journalNot applicablepeer-review

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Detail(s)

Original languageEnglish
Pages (from-to)122-150
Journal / PublicationPacific Basin Finance Journal
Volume20
Issue number1
Publication statusPublished - Jan 2012

Abstract

We explore the role of interest rate policy in the exchange rate determination process. Specifically, we derive exchange rate equations from interest rate rules that are theoretically optimal under a few alternative settings. The exchange rate equation depends on its underlying interest rule and its performance could vary across evaluation criteria and sample periods. The exchange rate equation implied by the interest rate rule that allows for interest rate and inflation inertia under commitment offers some encouraging results - exchange rate changes "calibrated" from the equation have a positive and significant correlation with actual data, and offer good direction of change prediction. Our exercise also demonstrates the role of the foreign exchange risk premium in determining exchange rates and the difficulty of explaining exchange rate variability using only policy based fundamentals. © 2011 Elsevier B.V.

Research Area(s)

  • Direction of change, Exchange rate determination, Foreign exchange risk premium, Mean squared prediction error, Taylor rule