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Money Supply Rules and Exchange Rate Dynamics

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  • Juha Tervala

Abstract

This paper examines the implications of monetary policy rules for exchange rate dynamics. I extend a standard New Open Economy Macroeconomics model with the introduction of a simple money supply rule, whereby central banks change their monetary policy if output diverges from potential output or if inflation diverges from the target inflation. A key result is that, in the case of permanent technology and monetary shocks, the nominal exchange rate does not follow a random walk; instead, the exchange rate undershoots its long-run value. An undershooting of the exchange rate derives from the active monetary policy that both countries conduct.

Suggested Citation

  • Juha Tervala, 2012. "Money Supply Rules and Exchange Rate Dynamics," International Economic Journal, Taylor & Francis Journals, vol. 26(4), pages 547-565, January.
    • Handle: RePEc:taf:intecj:v:26:y:2012:i:4:p:547-565
    DOI: 10.1080/10168737.2011.558517
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    References listed on IDEAS

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    1. Alan Sutherland, 2002. "International monetary policy coordination and financial market integration," International Finance Discussion Papers 751, Board of Governors of the Federal Reserve System (U.S.).
    2. Corsetti, Giancarlo, 2007. "New Open Economy Macroeconomics," CEPR Discussion Papers 6578, C.E.P.R. Discussion Papers.
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    Cited by:

    1. Works, Richard Floyd, 2016. "Econometric modeling of exchange rate determinants by market classification: An empirical analysis of Japan and South Korea using the sticky-price monetary theory," MPRA Paper 76382, University Library of Munich, Germany.

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