Should Central Banks React to Exchange Rate Movements?

1. Should Central Banks React to Exchange Rate Movements? 2nd Workshop on Macroeconomic Policy Research, Budapest, October 2-3, 2003

2. Empirical observation • Central banks respond with their interest rate instrument to exchange rate movements: • Evidence from VARs: • Clarida and Gertler (1997): Bundesbank • Brischetto and Voss (1999), Dungey and Pagan (2000): Australia • Evidence from direct estimation of monetary policy rules: • Clarida, Gali and Gerler (1998): Bundesbank, Bank of Japan, Bank of England • Gerlach and Smets (2000): Reserve Bank of New Zealand, Bank of Canada • Ades, Buscaglia and Masih (2002): Chile, Israel, South Africa, the Czech Republic and Mexico

3. Results from normative policy-evaluation studies • Taylor (2001): “Research to date indicates that monetary policy rules that react directly to the exchange rate, as well as to inflation and output, do not work much better in stabilizing inflation and real output and sometimes work worse than policy rules that do not react directly to the exchange rate”: • Small improvement of the macroeconomic performance of a central bank’s interest rate policy: Ball (1999), Svensson (2000), Batini et al. (2001), Leitemo and Söderström (2001); • Deterioration: Côté et al. (2002); • Mixed results: Taylor (1999).

4. Outline of the presentation • I. Reproducing the results from simulation studies • II. Explaining the results from simulation studies • III. Modifying the simulation studies in order to provide a rationale for the empirical results

5. I. Reproducing the results from simulation studies • Normative policy-evaluation approach Baseline macro- econometric model of the open economy monetary policy rule exogenous disturbances goal variables performance of the policy rules

6. The baseline macroeconometric model • Phillips curve: • IS curve: • Uncovered interest parity: • Real exchange rate: • stochastic disturbances • foreign variables: • risk premium (UIP) shock: • variances of the white-noise shocks:

7. A battery of simple policy rules two categories of rules Taylor rule open economy rules

8. Optimised simple rules in the baseline model • optimisation:

9. II. Explaining the results from simulation studies • Underlying exchange rate model: uncovered interest parity • The determinants of the spot exchange rate are • the foreign nominal interest rate; • the domestic nominal interest rate (the policy instrument); • the UIP disturbance (risk premium shocks).

10. Optimised policy rules under a perfectly holding UIP condition and constant foreign interest rates • No informational gain from responding to contemporaneous exchange rate movements: the interest rate is the only determinant of the exchange rate. • However, small gain from commitment to an inertial policy rule: the reaction to lagged exchange rate movements can be regarded as substitute for interest rate smoothing.

11. III. Modifying the simulation studies in order to provide arationale for empirical results • Introducing the idea of exchange rate uncertainty • Discussing the consequences of exchange rate uncertainty

12. Exchange rate uncertainty • The central bank considers one specific exchange rate model to be most likely (the supposedly “true” exchange rate model): • baseline model with uncovered interest parity with known stochastic properties ( and ) • which is used – as before – for deriving the policy rules. • There are, however, a range of alternative specifications according to which the exchange rate may behave. • These specifications occur with an unknown probability distribution. • They incorporate various elements that are typically employed in the literature to explain deviations from uncovered interest parity.

13. Modelling exchange rate uncertainty

14. The set-up of the uncertainty evaluation exogenous disturbances (demand & supply shocks as in the baseline model, exchange rate shocks according to U1 to U6) monetary policy rules R1 to R6 derived from the baseline model IS curve + Phillips curve + U1/U2/U3/U4/U5/U6 goal variables performance of the policy rules

15. Performance of monetary policy under U1 Loss

16. Performance of monetary policy under U2 Loss

17. Performance of monetary policy under U3 Loss

18. Performance of monetary policy under U4 Loss

19. Performance of monetary policy under U5 Loss

20. Performance of monetary policy under U6 Loss

21. Summary of the results

22. The quest for robustness in monetary policy • A policy rule with a feedback from the lagged and the current real exchange rate is superior to a Taylor-type rule according to which the central bank only responds to movements in domestic goal variables. • Such a policy rule that performs best across a range of structural models is called a robust policy rule since it best possibly insulates the economy from the negative consequences of uncertainty about the true exchange rate model. • Reacting to exchange rate movements reflects the monetary policymaker‘s quest for robustness in world which is surrounded by a high degree of uncertainty about the true determination of the exchange rate.

23. Conclusion • The reason why normative policy-evaluation studies typically come to the result that responding to exchange rate movements is redundant stems from their assumption of a well-defined and reliable relationship between the interest rate and the exchange rate. • Relaxing this assumption and allowing for uncertainty about this relationship provides an economic rationale for the empirically observable interest rate response to exchange rate movements.

24. T H A N K Y O U