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

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.