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Robust Taylor rules under heterogeneity in currency trade

International Economics and Economic Policy volume 6, pages 283–313 (2009)Cite this article

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Abstract

It is demonstrated in this paper that the exchange rate should be included in the Taylor rule when there is heterogeneity in currency trade to have a determinate and least squares learnable rational expectations equilibrium that also is desirable in an inflation rate targeting regime. Moreover, for certain Taylor rule parameterizations, these properties of the interest rate rule are robust against the degree of technical trading in currency trading.

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Notes

  1. Firstly, write the second equation in (3) on relative form, Δs t . Secondly, substitute the equation for Δs t into the first equation in (3) and solve for π H,t. Thirdly, shift the equation for π H,t one time period forward in time, \( \pi_{H,t + 1}^e \). Fourthly, substitute the equation for \( \pi_{H,t + 1}^e \) into the first equation in (2) and the first equation in (4) is derived. Finally, substitute the equations for π H,t and \( \pi_{H,t + 1}^e \) into the second equation in (2) and the second equation in (4) is derived.

  2. MATLAB routines for this purpose are available on request from the authors.

  3. As will be discussed in Section 3.2, when there is a determinate REE in the economy, agents who use fundamental analysis in currency trade will also be able to learn the REE over time via least squares if the dating of expectations is time period t. Thus, to keep the number of figures at a minimum, the regions in the figures are not only regions for a determinate REE, but also regions for a least squares learnable REE.

  4. Consequently, the regions in Figs. 1, 2, 3, 4 and 5 are also determinacy regions when a contemporaneous expectations specification of the Taylor rule is used by the monetary authority in policy-making, even if it is written “contemporaneous data specification of the Taylor rule” in some of the figures (see Figs. 1, 2a, 3a, 4a and 5a). As will be discussed in Section 3.2, this is because there are parameterizations of the contemporaneous expectations specification of the Taylor rule that give rise to a determinate REE that is not stable under least squares learning.

  5. To have the economy’s ALM, a possibly non-rational forecast of the next time period’s state of the economy should be substituted into the model in (17) allowing for non-rational expectations. However, since the mathematical expression in (20) would not be affected by this, (20) is also the economy’s ALM. Below, when a contemporaneous expectations specification of the Taylor rule is used by the monetary authority in policy-making, we will focus on the derivation of the economy’s ALM.

  6. \( H(x) = \left\{ {\begin{array}{*{20}c} {1,\;x \ge 0,} \hfill \\ {0,\;x < 0.} \hfill \\ \end{array} } \right. \)

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Acknowledgement

This paper has benefited from presentations at various conferences and seminars, and the authors acknowledge comments by Seppo Honkapohja, Karl-Gustaf Löfgren, Rajesh Singh, Tomas Sjögren, Jouko Vilmunen, Anders Vredin and three anonymous referees. The first author is also grateful to the OP Bank Group Foundation for a research grant. The usual disclaimer applies.

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Authors and Affiliations

  1. Department of Economics and Statistics, Åbo Akademi University, FIN-20500, Turku, Finland

    Mikael Bask

  2. Department of Economics, Umeå University, SE-901 87, Umeå, Sweden

    Carina Selander

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  1. Mikael Bask
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  2. Carina Selander
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Correspondence to Mikael Bask.

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Bask, M., Selander, C. Robust Taylor rules under heterogeneity in currency trade. Int Econ Econ Policy 6, 283–313 (2009). https://doi.org/10.1007/s10368-009-0131-6

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