1. Timo Wollmershäuser Institute for Economic Research at the University of Munich 2 nd Workshop on Macroeconomic Policy Research, Budapest, October 2-3, 2003 Should Central Banks React to Exchange Rate Movements?

2. Slide 2 Empirical observation Central banks respond with their interest rate instrument to exchange rate movements: Evidence from VARs: - Clarida and Gertler (1997): Bundesbank - Brischetto and Voss (1999), Dungey and Pagan (2000): Australia Evidence from direct estimation of monetary policy rules: - Clarida, Gali and Gerler (1998): Bundesbank, Bank of Japan, Bank of England - Gerlach and Smets (2000): Reserve Bank of New Zealand, Bank of Canada - Ades, Buscaglia and Masih (2002): Chile, Israel, South Africa, the Czech Republic and Mexico

3. Slide 3 Results from normative policy-evaluation studies Taylor (2001): Research to date indicates that monetary policy rules that react directly to the exchange rate, as well as to inflation and output, do not work much better in stabilizing inflation and real output and sometimes work worse than policy rules that do not react directly to the exchange rate: Small improvement of the macroeconomic performance of a central banks interest rate policy: Ball (1999), Svensson (2000), Batini et al. (2001), Leitemo and Söderström (2001); Deterioration: Côté et al. (2002); Mixed results: Taylor (1999).

4. Slide 4 Outline of the presentation I. Reproducing the results from simulation studies II. Explaining the results from simulation studies III. Modifying the simulation studies in order to provide a rationale for the empirical results

5. Slide 5 I. Reproducing the results from simulation studies Normative policy-evaluation approach Baseline macro- econometric model of the open economy goal variables exogenous disturbances monetary policy rule performance of the policy rules

6. Slide 6 The baseline macroeconometric model Phillips curve: IS curve: Uncovered interest parity: Real exchange rate: stochastic disturbances - foreign variables: - risk premium (UIP) shock: - variances of the white-noise shocks:

7. Slide 7 A battery of simple policy rules open economy rulesTaylor rule two categories of rules

8. Slide 8 Optimised simple rules in the baseline model optimisation:

9. Slide 9 II. Explaining the results from simulation studies Underlying exchange rate model: uncovered interest parity The determinants of the spot exchange rate are the foreign nominal interest rate; the domestic nominal interest rate (the policy instrument); the UIP disturbance (risk premium shocks).

10. Slide 10 Optimised policy rules under a perfectly holding UIP condition and constant foreign interest rates 1.No informational gain from responding to contemporaneous exchange rate movements: the interest rate is the only determinant of the exchange rate. 2.However, small gain from commitment to an inertial policy rule: the reaction to lagged exchange rate movements can be regarded as substitute for interest rate smoothing.

11. Slide 11 III.Modifying the simulation studies in order to provide a rationale for empirical results 1.Introducing the idea of exchange rate uncertainty 2.Discussing the consequences of exchange rate uncertainty

12. Slide 12 Exchange rate uncertainty The central bank considers one specific exchange rate model to be most likely (the supposedly true exchange rate model): baseline model with uncovered interest parity with known stochastic properties (and) which is used – as before – for deriving the policy rules. There are, however, a range of alternative specifications according to which the exchange rate may behave. These specifications occur with an unknown probability distribution. They incorporate various elements that are typically employed in the literature to explain deviations from uncovered interest parity.

13. Slide 13 Modelling exchange rate uncertainty

14. Slide 14 The set-up of the uncertainty evaluation IS curve + Phillips curve + U1/U2/U3/U4/U5/U6 goal variables monetary policy rules R1 to R6 derived from the baseline model exogenous disturbances (demand & supply shocks as in the baseline model, exchange rate shocks according to U1 to U6) performance of the policy rules

15. Slide 15 Performance of monetary policy under U1 Loss

16. Slide 16 Performance of monetary policy under U2 Loss

17. Slide 17 Performance of monetary policy under U3 Loss

18. Slide 18 Performance of monetary policy under U4 Loss

19. Slide 19 Performance of monetary policy under U5 Loss

20. Slide 20 Performance of monetary policy under U6 Loss

21. Slide 21 Summary of the results Exchange Rate Uncertainty Best Performing Policy Rule Second Best Performing Policy Rule U1R2R6 U2R6R2 U3R4 and R5R6 U4R2 and R6R4 and R5 U5R6R4 and R5 U6R2R6

22. Slide 22 The quest for robustness in monetary policy 1. A policy rule with a feedback from the lagged and the current real exchange rate is superior to a Taylor-type rule according to which the central bank only responds to movements in domestic goal variables. 2. Such a policy rule that performs best across a range of structural models is called a robust policy rule since it best possibly insulates the economy from the negative consequences of uncertainty about the true exchange rate model. 3. Reacting to exchange rate movements reflects the monetary policymakers quest for robustness in world which is surrounded by a high degree of uncertainty about the true determination of the exchange rate.

23. Slide 23 Conclusion 4. The reason why normative policy-evaluation studies typically come to the result that responding to exchange rate movements is redundant stems from their assumption of a well-defined and reliable relationship between the interest rate and the exchange rate. 5. Relaxing this assumption and allowing for uncertainty about this relationship provides an economic rationale for the empirically observable interest rate response to exchange rate movements.

24. Slide 24 T H A N K Y O U