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Nonlinearities in the Real Exchange Rate and Monetary Policy: Interest Rate Rules Reconsidered

By Konstantinos D. Mavromatis

Abstract

Empirical research during the last ten years has found significant evidence in favour of a nonlinear-threshold type behaviour of the real exchange rate. Interest rate rules which include the exchange rate appear to have either an insignificant effect on or generate small coefficients for the real exchange rate. However, the empirical studies do not take into account the nonlinear behaviour of the exchange rate. The inclusion of nonlinearities in the real exchange rate could imply nonlinear behaviour in the interest rate rule, whenever the exchange rate is included. We use a two-country sticky price model to show that nonlinear Taylor-type rules where the exchange rate is included lead to lower variation in output and inflation.Taylor rules, real exchange rate, nonlinearities

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