Monetary Policy and Real Exchange Rate Dynamics in Sticky-Price Models

Carvalho, Carlos; Nechio, Fernanda; Yao, Fang

doi:10.24148/wp2014-17

Working Paper

Monetary Policy and Real Exchange Rate Dynamics in Sticky-Price Models

Abstract: We study how real exchange rate dynamics are affected by monetary policy in dynamic, stochastic, general equilibrium, sticky-price models. Our analytical and quantitative results show that the source of interest rate persistence ? policy inertia or persistent policy shocks ? is key. When the monetary policy rule has a strong interest rate smoothing component, these models fail to generate high real exchange rate persistence in response to monetary shocks, as policy inertia hampers their ability to generate a hump-shaped response to such shocks. Moreover, in the presence of persistent monetary shocks, increasing policy inertia may decrease real exchange rate persistence.

Keywords: real exchange rates; monetary policy; interest rate smoothing; PPP puzzle; persistence;

JEL Classification: E0; F3; F41;

https://doi.org/10.24148/wp2014-17