Working Paper: NBER ID: w13010
Authors: Richard Clarida; Daniel Waldman
Abstract: We show in a simple—but robust—theoretical monetary exchange rate model that the sign of the covariance between an inflation surprise and the nominal exchange rate can tell us something about how monetary policy is conducted. Specifically, we show that 'bad news' about inflation—that it is higher than expected—can be 'good news' for the nominal exchange rate—that it appreciates on this news—if the central bank has an inflation target that it implements with a Taylor Rule. The empirical work in this paper examines point sampled data on inflation announcements and the reaction of nominal exchange rates in 10 minute windows around these announcements for 10 countries and several different inflation measures for the period July 2001 through March 2005. When we pool the data, we do in fact find that bad news about inflation is indeed good news for the nominal exchange rate, that the results are statistically significant, and that the r-square is substantial, in excess of 0.25 for core measures of inflation. We also find significant differences comparing the inflation targeting countries and the two non-inflation targeting countries.
Keywords: Inflation; Exchange Rate; Monetary Policy; Taylor Rule; Inflation Targeting
JEL Codes: E31; F31
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| bad news about inflation (higher than expected inflation) (E31) | appreciation of nominal exchange rate (F31) |
| inflation targeting regime (Taylor rule) (E52) | appreciation of nominal exchange rate (F31) |
| bad news about inflation (higher than expected inflation) (E31) | positive changes in nominal exchange rate (F31) |
| inflation targeting countries (E31) | significant correlation between inflation surprises and exchange rate changes (F31) |
| non-inflation targeting countries (E31) | no significant effect of inflation surprises on nominal exchange rate (F31) |
| credibility of inflation targeting (E52) | observed outcomes in exchange rate dynamics (F31) |