Sources of exchange rate fluctuations with Taylor rule fundamentals

a r t i c l e i n f o This paper investigates the sources of exchange rate fluctuations when monetary policy follows a Taylor rule interest rate reaction function. We first present a simple dynamic exchange rate model with Taylor rule fundamentals which is triangular in the long-run impacts of shocks to the output market, the interest rate differential, and the Taylor rule. We then proceed to assess the relative importance of various shocks in exchange rate determination by estimating a structural VAR with long-run identification restrictions based on the triangular structure of the model. We find demand shocks to be less important than in earlier VAR studies, with both supply shocks and nominal shocks explaining a substantial part of real exchange rate fluctuations. Standard monetary models of exchange rate determination have long been discredited by their failure to explain, let alone predict, exchange rate behavior, as forcefully documented by Meese and Rogoff (1983) and Flood and Rose (1995). A new strand of literature identifies one of the major shortcomings of traditional exchange rate models in paying too little attention to the market's expectations of future values of the macroeconomic fundamentals (Bacchetta and van Wincoop, 2006; Engel and West, 2004, 2005). In particular, most extant exchange rate models fail to incorporate the endogeneity of monetary policy. But if exchange rates are primarily driven by expectations, then correctly modeling monetary policy is crucial (Engel et al., 2007). Changes in current economic fundamentals may have little direct impact on exchange rates, but may nevertheless affect the latter strongly through their effect on changes in expectations regarding the monetary policy response. The endogeneity of monetary policy can be modeled by means of a Taylor rule with the interest rate as the policy instrument. In such an environment, interest rates respond to inflation, the output gap and possibly the exchange rate as well. It turns out that models of the open economy with a Taylor rule display exchange rate behavior quite different from traditional exchange rate models. For example, whereas in standard flexible-price monetary models an increase in the current inflation rate depreciates the exchange rate, in Taylor rule models the exchange rate appreciates because higher inflation induces expectations of tighter future monetary policy (Clarida and Waldman, 2007). The emerging evidence on the empirical performance of Taylor rule models of the open economy is quite encouraging. Engel and West (2006) and Mark …