Rational expectations, changing monetary policy rules, and real exchange rate dynamics
Journal
Journal of Banking and Finance
Journal Volume
36
Journal Issue
10
Pages
2824-2836
Date Issued
2012
Author(s)
Abstract
This paper reexamines the explanatory power of Taylor rule fundamentals for real exchange rate determination. We assume the agents know the time-varying parameters in central bank policy rules. The empirical results suggest that a monetary policy rule with regime switching is better able to explain the real Deutschemark/dollar exchange rate from 1976 to 1998 compared with a fixed-regime monetary policy rule. The findings show the importance of accounting for the expectation formation effect in changing policy rules as emphasized by the Lucas critique. Ignoring these effects can undermine the value of the rational expectations models. © 2012 Elsevier B.V..
Type
journal article