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The Complex Response of Monetary Policy to the Exchange Rate

Author

Listed:
  • Ram Sharan Kharel

    (Brunel University)

  • Christopher Martin

    (Brunel University)

  • Costas Milas

    (Keele University, Centre for Economic Research and School of Economic and Management Studies)

Abstract

We estimate a flexible non-linear monetary policy rule for the UK to examine the response of policymakers to the real exchange rate. We have three main findings. First, policymakers respond to real exchange rate misalignment rather than to the real exchange rate itself. Second, policymakers ignore small deviations of the exchange rate; they only respond to real exchange under-valuations of more than 4\% and over-valuations of more than 5\%. Third, the response of policymakers to inflation is smaller when the exchange rate is over-valued and larger when it is under-valued. None of these responses is allowed for in the widely-used Taylor rule, suggesting that monetary policy is better analysed using a more sophisticated model, such as the one suggested in this paper.

Suggested Citation

  • Ram Sharan Kharel & Christopher Martin & Costas Milas, 2006. "The Complex Response of Monetary Policy to the Exchange Rate," Keele Economics Research Papers KERP 2006/17, Centre for Economic Research, Keele University.
    • Handle: RePEc:kee:kerpuk:2006/17
    Note: We thank Kevin Lee and Roberto Gonzalez for useful comments and suggestions.
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    File URL: https://www.keele.ac.uk/depts/ec/wpapers/kerp0617.pdf
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    Cited by:

    1. Onanuga, Abayomi & Oshinloye, Michael & Onanuga, Olaronke, 2015. "Monetary Policy-Making in Nigeria: Does evidence support augmented Taylor Rule?," MPRA Paper 83329, University Library of Munich, Germany.
    2. Anh Dinh Minh Nguyen, 2017. "U.K. Monetary Policy under Inflation Targeting," Bank of Lithuania Working Paper Series 41, Bank of Lithuania.
    3. Hoda Selim, 2012. "Exploring the Role of the Exchange Rate in Monetary Policy in Egypt," Working Papers 733, Economic Research Forum, revised 2012.
    4. Kevin Lee & Nilss Olekalns & Kalvinder Shields, 2013. "Meta Taylor Rules for the UK and Australia; Accommodating Regime Uncertainty in Monetary Policy Analysis Using Model Averaging Methods," Manchester School, University of Manchester, vol. 81, pages 28-53, October.
    5. Khvostova, I. & Novak, A., 2014. "Monetary Stabilization: Modeling and Estimation for Russian Economy in 2004-2012," Journal of the New Economic Association, New Economic Association, vol. 23(3), pages 89-105.

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    More about this item

    Keywords

    Monetary policy; asset prices; nonlinearity;
    All these keywords.

    JEL classification:

    • C51 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Construction and Estimation
    • C52 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Evaluation, Validation, and Selection
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies

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