Essays on exchange rate models under a Taylor rule type monetary policy

by 1968- Kim, Hyeongwoo

This dissertation develops three exchange rate models that explicitly incorporate a Taylor Rule type monetary policy in order to study its implications on exchange rate dynamics. Since the seminal work of Taylor (1993), the Taylor Rule has become a new standard in the literatures on exchange rates as well as monetary policy. The results reported in this dissertation imply that the Taylor Rule may be very useful in understanding exchange rate dynamics better. My first two essays attempt to improve on the performance of the existing techniques for estimating the half-life of Purchasing Power Parity (PPP) deviations. The first essay, ”Half-Life Estimation under the Taylor Rule,” addresses two perennial problems in the current PPP literature, namely, unreasonably long half-life estimates of PPP deviations (PPP Puzzle; Rogoff, 1996) and extremely wide confidence intervals for half-life point estimates (Murray and Papell, 2002). Using a model that incorporates a forward looking version Taylor Rule in a dynamic system of exchange rates and inflation, I obtain significantly tighter confidence intervals along with reasonably short half-lives for PPP deviations, which is roughly consistent with micro evidence. My model also indicates that real exchange rate dynamics may differ greatly, depending on the pattern of systematic central bank responses to the inflation rate. In the second essay, ”Half-Life Estimation under the Taylor Rule: Two Goods Model,” I estimate and compare half-lives of PPP deviations for PPI- and CPI-based ii real exchange rates. As an extension of my first essay (single good model), we employ a GMM system method in a two-goods model, where the central bank attempts to keep general inflation (e.g., GDP deflator inflation) in check. In a similar framework that employs a money demand function instead of the Taylor Rule, Kim (2004) reported much shorter half-life point estimates for the non-service consumption deflators than those for service consumption deflators, though with quite wide confidence intervals. In contrast, I find that half-life estimates were about the same irrespective of the choice of aggregate price indexes, which is consistent with many other studies that reported only moderate or no difference. Most importantly, I obtain much smaller standard errors that enables us to make statistically meaningful comparisons between the sizes of half-life estimates. Our model also shows that rationally expected future Taylor Rule fundamentals help understand real exchange rate dynamics only when the central bank responds to general inflation aggressively enough. Finally, the third essay, ”Local-Currency Pricing, Technology Diffusion, and the Optimal Interest Rate Rule,” studies optimal monetary policy and its implications on exchange rate regimes in a dynamic stochastic general equilibrium model that features sticky-price, local-currency pricing, and technology diffusion. The main findings of this essay are twofold. First, in response to a favorable real shock, central banks may raise nominal interest rates despite price-stickiness and local-currency pricing, which seems to be consistent with empirical evidence of rising nominal interest rates during economic boom. This outcome is exactly opposite to the Rogoff’s (2004) prediction as well as those of many others. Second, central banks respond identically to technology shocks that occur in tradables sectors so that optimal monetary policies do not require any exchange rate change. However, central banks respond oppositely iii to real shocks in nontradables sectors, and the resulting interest rate differential calls for exchange rate changes. Therefore, compared with Duarte and Obstfeld’s (2004) results, this outcome implies that benefits of flexible exchange rates could be quite limited if technology shocks in nontradables sectors occur infrequently. This essay also finds a case that central banks optimally do not respond to any technology shock in tradables sectors, which may be related to a dirty-float system of exchange rates. iv To my parents and my family v