We estimate a flexible non-linear monetary policy rule for the UK to examine
the response of policymakers to the real exchange rate. We have three main
findings. First, policymakers respond to real exchange rate misalignment
rather than to the real exchange rate itself. Second, policymakers ignore
small deviations of the exchange rate; they only respond to real exchange
under-valuations of more than 4% and over-valuations of more than 5%.
Third, the response of policymakers to inflation is smaller when the exchange
rate is over-valued and larger when it is under-valued. None of these
responses is allowed for in the widely-used Taylor rule, suggesting that
monetary policy is better analysed using a more sophisticated model, such as
the one suggested in this paper
