Interest Rate Rules, Exchange Market Pressure, and Successful Exchange Rate Management

Tinbergen Institute Discussion Paper 16-034/VI

42 Pages Posted: 29 Apr 2016

See all articles by Franc Klaassen

Franc Klaassen

University of Amsterdam - Research Institute in Economics & Econometrics (RESAM); Tinbergen Institute

Konstantinos Mavromatis

University of Amsterdam - Faculty of Economics and Business (FEB)

Date Written: April 28, 2016

Abstract

Central banks with an exchange rate objective set the interest rate in response to what they call ''pressure.'' Instead, existing interest rate rules rely on the exchange rate minus its target. To stay closer to actual policy, we introduce a rule that uses exchange market pressure (EMP), the tendency of the currency to depreciate. Our rule can also explain a high interest rate even if the actual exchange rate is on target, in contrast to traditional rules. A further improvement is that the coefficient for EMP depends on the interest rate effectiveness: the rate should be used less if it is more effective. This shows how policy makers should adapt their policy in case of a structural change to avoid missing their objective. Our rule can be applied to many regimes, from the float to the fixed, and to many models, such as the New Keynesian model, as we illustrate.

Keywords: DSGE, exchange market pressure, exchange rate regime, fixed exchange rate, monetary policy, open economy Taylor rule

JEL Classification: E43, E52, F31, F33

Suggested Citation

Klaassen, Franc and Mavromatis, Konstantinos, Interest Rate Rules, Exchange Market Pressure, and Successful Exchange Rate Management (April 28, 2016). Tinbergen Institute Discussion Paper 16-034/VI. Available at SSRN: https://ssrn.com/abstract=2772503 or http://dx.doi.org/10.2139/ssrn.2772503

Franc Klaassen (Contact Author)

University of Amsterdam - Research Institute in Economics & Econometrics (RESAM) ( email )

Roetersstraat 11
Amsterdam
Netherlands
+31 20 525 4191 (Phone)
+31 20 525 4254 (Fax)

Tinbergen Institute ( email )

Burg. Oudlaan 50
Rotterdam, 3062 PA
Netherlands

Konstantinos Mavromatis

University of Amsterdam - Faculty of Economics and Business (FEB) ( email )

Roetersstraat 11
Amsterdam, 1018 WB
Netherlands

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