Premium
Trend Fundamentals and Exchange Rate Dynamics
Author(s) -
Huber Florian,
Kaufmann Daniel
Publication year - 2020
Publication title -
economica
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 1.532
H-Index - 65
eISSN - 1468-0335
pISSN - 0013-0427
DOI - 10.1111/ecca.12334
Subject(s) - exchange rate , econometrics , economics , natural rate of unemployment , inflation (cosmology) , taylor rule , unemployment , monetary policy , unemployment rate , macroeconomics , central bank , physics , theoretical physics
We estimate a multivariate unobserved components stochastic volatility model to explain the dynamics of a panel of six exchange rates against the US dollar. The empirical model is based on the assumption that two countries’ monetary policy strategies may be well described by Taylor rules with a time‐varying inflation target, a time‐varying natural rate of unemployment, and interest rate smoothing. Compared to the existing literature, our model simultaneously provides estimates of the latent components included in a typical Taylor rule specification and the model‐based real exchange rate. Our estimates closely track major movements along with important time series properties of real and nominal exchange rates across all currencies considered, outperforming a benchmark model that does not account for changes in trend inflation and trend unemployment. More precisely, the proposed approach improves on competing models in tracking the actual evolution of the real exchange rate in terms of simple correlations while it appreciably improves on simpler competitors in terms of matching the persistence of the real exchange rate.