Measuring potential market risk

The difference between market risk and potential market risk is emphasized and a measure of the latter risk is proposed. Specifically, it is argued that the spectrum of smooth Lyapunov exponents can be utilized in what we call (l, s2)-analysis, which is a method to monitor the aforementioned risk measures. The reason is that these exponents focus on the stability properties (l) of the stochastic dynamic system generating asset returns, while more traditional risk measures such as value-at-risk are concerned with the distribution of returns (s2).market risk; potential market risk; smooth Lyapunov exponents; stochastic dynamic system; value-at-risk

Instrument rules in monetary policy under heterogeneity in currency trade

We embed different instrument rules into a New Keynesian model for a small open economy that is augmented with technical trading in currency trade to examine the prerequisites for monetary policy. Specifically, this paper focuses on conditions for a determinate, least-squares learnable rational expectations equilibrium (REE). Under an interest rate rule with only contemporaneous macroeconomic data, the intensity of technical trading or trend-seeking in currency trade does not affect these conditions, except in the case of an extensive use of trend-seeking. On the other hand, if the central bank uses only forward-looking information in its interest rate rule, a determinate and learnable REE is a less likely outcome when trend-seeking in currency trade becomes more popular. The interest rate rule followed by the central bank in the model incorporates interest rate smoothing.determinacy; DSGE model; interest rate rule; least-squares learning; technical trading

A case for interest rate smoothing

The aim of this paper is to determine whether it would be desirable from the perspective of macroeconomic balance for central banks to take account of nominal exchange rate movements when framing monetary policy. The theoretical framework is a small, open DSGE economy that is closed by a Taylor rule for the monetary authority, and a determinate REE that is least-squares learnable is defined as a desirable outcome in the economy. When the policy rule contains contemporaneous data on the output gap and the CPI inflation rate, the monetary authority does not have to consider the exchange rate as long as there is sufficient inertia in policy-making. In fact, due to a parity condition on the international asset market, interest rate smoothing and a response to changes in the nominal exchange rate are perfectly intersubstitutable in monetary policy. In other words, we give a rationale for the monetary authority to focus on the change in the nominal interest rate rather than its level in policy-making. Thus, we have a case for interest rate smoothing.determinacy; E-stability; foreign exchange; inertia; Taylor rule

Optimal monetary policy in a hybrid New Keynesian model with a cost channel

This study shows that an expectations-based optimal policy rule has desirable properties in a standard macroeconomic model incorporating a cost channel for monetary disturbances and inflation rate expectations that are partly backward-looking. Specifically, optimal monetary policy under commitment is associated with a determinate REE that is stable under learning, whereas, under discretion, the central bank has to be sufficiently inflation averse for the equilibrium to have these properties.commitment; determinacy; discretion; expectations-based rule; least squares learning

Adaptive learning in an expectational difference equation with several lags: selecting among learnable REE

It is demonstrated in this paper that adaptive learning in least squares sense may be incapable to reduce, in a satisfactory way, the number of attainable equilibria in a rational expectations model. The model inves-tigated, as an illustration, is the monetary approach to exchange rate determination that is augmented with technical trading in the currency market in the form of moving averages since it is the most commonly used technique according to questionnaire surveys. Because of technical trading in foreign exchange, the current exchange rate is dependent on jmax lags of the exchange rate, and the model has, therefore jmax + 1 nonbubble rational expectations equilibria (REE), where most of them are adaptively learnable. Howe-ver, by assuming that a solution to the model should have a solution to a nested model as its limit, it is possible to single out a unique equilibrium among the adaptively learnable equilibria that is economically meaningful.asset pricing; heterogenous agents; least squares learnability; rational expectations equilibria and technical trading

Optimal monetary policy under heterogeneity in currency trade

We embed an expectations-based optimal policy rule into a DSGE model for a small open economy that is augmented with trend extrapolation or chartism, which is a form of technical trading, in currency trade to examine the prerequisites for monetary policy. We find that a unique REE that is least-squares learnable is often the outcome when there is a limited amount of trend extrapolation, but that a less flexible inflation rate targeting may cause a multiplicity of REE. We also compute impulse-response functions for key macroeconomic variables to study how the economy returns to steady state after being hit by a shock.determinacy; DSGE model; least-squares learning; targeting rule; technical trading; monetary policy

Long swings and chaos in the exchange rate in a DSGE model with a Taylor rule

A DSGE model with a Taylor rule is augmented with an evolutionary switching between technical and fundamental analyses in currency trade, where the fractions of these trading tools are determined within the model. Then, a shock hits the economy. As a result, chaotic dynamics and long swings may occur in the exchange rate, which are appealing features of the model given existing empirical evidence on chaos and long swings in exchange rate fluctuations.chaotic dynamics; foreign exchange; fundamental analysis; monetary policy; technical analysis

Chartists and Fundamentalists in the Currency Market and the Volatility of Exchange Rates

The purpose of this paper is to implement theoretically, the empirical observation that the relative importance of fundamental versus technical analysis in the foreign exchange market depends on the planning horizon. For shorter planning horizons, more weight is placed on technical analysis, while more weight is placed on fundamental analysis for longer planning horizons. The theoretical framework is the Dornbusch (1976) overshooting model. The perfect foresight path near long-run equilibrium is derived, and it is shown that the magnitude of exchange rate overshooting is larger than in the Dornbusch (1976) model. Specifically, the extent of overshooting depends inversely on the planning horizon.Chartists; Excess Volatility; Foreign Exchange; Fundamentalists; Moving Averages; Overshooting; Technical Analysis

Fundamentals and technical trading: behaviour of exchange rates in the CEECs

We present a model of exchange rates, which incorporates the monetary approach and technical trading, and we present the reduced form based on the minimal state variable solution, where both fundamentals and backward-looking term determine the spot exchange rates. Finally, we estimate the impact of the monetary fundamentals for a panel of Central and Eastern European countries (Czech Republic, Poland, Romania and Slovakia) in the second half of the 1990s as well as the complete model of exchange rate determination for daily data over the more recent free-floating period.foreign exchange market; fundamental analysis; panel cointegration; technical analysis

Robust Taylor rules in an open economy with heterogeneous expectations and least squares learning

The aim of this paper is threefold: (i) to investigate if there is a unique rational expectations equilibrium (REE) in the small open economy in Galí and Monacelli (2005) that is augmented with technical trading in the foreign exchange market; (ii) to investigate if the unique REE is adaptively learnable in a recursive least squares sense; and (iii) to investigate if the unique and adaptively learnable REE is desirable in an inflation rate targeting regime in the sense that a low and not too variable CPI inflation rate in equilibrium is achieved. The monetary authority is using a Taylor rule when setting the nominal interest rate, and we investigate numerically the properties of the model developed. A main conclusion is that the monetary authority should increase (decrease) the interest rate when the CPI inflation rate increases (decreases) and when the currency gets stronger (weaker) to have a desirable rule that is robust with respect to the degree of technical trading in the foreign exchange market. Thus, the value of the currency is a better response variable than the output gap in the most desirable parametrizations of the interest rate rule.determinacy; foreign exchange; inflation rate targeting regime; interest rate rule; robust monetary policy; technical trading