Handbook of Exchange Rates

2.4 New Directions in Exchange-Rate Modeling

2.4.1 TAKING REACTION FUNCTIONS SERIOUSLY

One strand of development in macroeconomic-based models has involved the incorporation of central bank reaction functions into exchange-rate models. Recent research reports that out-of-sample exchange-rate forecasting can be improved by incorporating monetary policy reaction functions (Taylor rules) into standard models. Essentially, output gaps and inflation gaps are then brought into the determination of exchange rates.

Engel and West (2005) were the first to incorporate Taylor rule fundamentals in a formal derivation of a model of exchange rates. By analyzing the dollar exchange rate, they posited a standard Taylor rule for the United States, and an interest rate targeting rule for the foreign country that incorporated an exchange-rate gap, where the foreign country targets a PPP value of the nominal exchange rate. Combined with interest rate parity (allowing for an exchange risk premium), they solve out for the present value expression for the exchange rate. One of the implications of this present value relationship is, with a discount factor close to unity, the exchange rate should be essentially unpredictable. In this context, there is no “exchange rate disconnect,” that is, there is no puzzle why the exchange rate does not seem to be predictable on the basis of currently observed fundamentals.

Another implication of the model with highly persistent fundamentals is that the exchange rate ...