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Federal Reserve Bank of San Francisco
Working Paper Series
Monetary Policy and Real Exchange Rate Dynamics in Sticky-Price Models
Carlos Carvalho
Fernanda Nechio
Fang Yao
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.


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Carlos Carvalho & Fernanda Nechio & Fang Yao, Monetary Policy and Real Exchange Rate Dynamics in Sticky-Price Models, Federal Reserve Bank of San Francisco, Working Paper Series 2014-17, Jul 2014, revised Sep 2017.
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Keywords: real exchange rates; monetary policy; interest rate smoothing; PPP puzzle; persistence
DOI: 10.24148/wp2014-17
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