Real exchange rate dynamics: Relative importance of Taylor-rule fundamentals, monetary policy shocks, and risk-premium shocks

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Abstract

We first show that the solution to the real exchange rate under the Taylor rule with interest rate smoothing can have two alternative representations—one based on a first-order difference equation and the other based on a second-order difference equation. Then, by comparing error terms from these two alternative representations and analyzing their second moments, we evaluate the relative importance of Taylor-rule fundamentals, monetary policy shocks, and risk-premium shocks in the dynamics of the real exchange rate. Empirical results suggest that the risk-premium shock is the largest contributor to real exchange rate movements for all the countries examined, with the Taylor-rule fundamentals and monetary policy shocks playing a limited role. These results are robust to various alternative sets of parameter values considered for the Taylor rule with interest rate smoothing.

Original languageEnglish
JournalReview of International Economics
DOIs
Publication statusAccepted/In press - 2018 Jan 1

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real exchange rate
monetary policy
premium
interest rate
smoothing

ASJC Scopus subject areas

  • Geography, Planning and Development
  • Development

Cite this

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title = "Real exchange rate dynamics: Relative importance of Taylor-rule fundamentals, monetary policy shocks, and risk-premium shocks",
abstract = "We first show that the solution to the real exchange rate under the Taylor rule with interest rate smoothing can have two alternative representations—one based on a first-order difference equation and the other based on a second-order difference equation. Then, by comparing error terms from these two alternative representations and analyzing their second moments, we evaluate the relative importance of Taylor-rule fundamentals, monetary policy shocks, and risk-premium shocks in the dynamics of the real exchange rate. Empirical results suggest that the risk-premium shock is the largest contributor to real exchange rate movements for all the countries examined, with the Taylor-rule fundamentals and monetary policy shocks playing a limited role. These results are robust to various alternative sets of parameter values considered for the Taylor rule with interest rate smoothing.",
author = "Chang-Jin Kim and Cheolbeom Park",
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