Is Bad News about Inflation Good News for the Exchange Rate?
Is Bad News about Inflation Good News for the Exchange Rate?
And, If So, Can That Tell Us Anything about the Conduct of Monetary Policy?
This chapter asks whether the response of an asset price (in this case the exchange rate) to a nonpolicy shock (in this case a surprise in inflation) can tell us something about how monetary policy is conducted. It shows 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, it shows 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.
Keywords: asset price, exchange rate, inflation, monetary policy, Taylor Rule
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