Working Paper: NBER ID: w1306
Authors: David H. Papell
Abstract: This paper investigates the relationship between the new monetary control procedures, implemented by the Federal Reserve Board in October 1979, and the subsequent increase in exchange rate variability for the United States. It shows that, in the context of a stochastic, rational expectations model,exchange rate variability minimizing monetary policy is identical to the policy which, in a deterministic, perfect foresight model, would place the economy on the borderline between exchange rate overshooting and undershooting. The model is estimated for the United States since generalized floating began in 1973. The new monetary control procedures have had two opposite effects. Monetary policy has become less accommodative, increasing exchange rate variability through overshooting. On the other hand ,systematic deviations from uncovered interest rate parity, which can be attributed to exchange risk, have also increased. These increase exchange rate variability through undershooting. It is shown that the latter dominate the former, providing an explanation of increased exchange rate variability consistent with undershooting, not with overshooting.
Keywords: Monetarist monetary policy; Exchange risk; Exchange rate variability
JEL Codes: E52; F31
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| less accommodative monetary policy (E49) | increased exchange rate variability (F31) |
| increased exchange risk (F31) | systematic deviations from uncovered interest rate parity (F31) |
| systematic deviations from uncovered interest rate parity (F31) | increased exchange rate variability (F31) |
| less accommodative monetary policy (E49) | increased exchange rate variability through overshooting (F31) |
| increased exchange risk (F31) | increased exchange rate variability through undershooting (F31) |