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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. Flood and Rose

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Learning, Monetary Policy Rules, and Real Exchange Rate Dynamics

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  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-Rogoff’s 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. The REE path: Inflation, output gap differentials follow VAR(p) • Forecasting: Companion form • Estimation

  21. The REE path: Pricing by real interest parity

  22. REE Solution

  23. Learning Path Given Generate Given Perceived Law of Motion

  24. Actual Law of Motion

  25. Update coefficients The VAR Interest Differential Real Exchange Rate Gain

  26. Alternative gain specifications

  27. 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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