When the Bubble Bursts: Monetary Policy Rules and Foreign Exchange Market Behavior

44 Pages Posted: 17 Jan 2017

See all articles by Nicoletta Batini

Nicoletta Batini

International Monetary Fund (IMF)

Edward Nelson

Federal Reserve Board

Date Written: October 24, 2000


We examine the effects of a “bubble” in the foreign exchange market, defined as an exogenous process that temporarily shifts the exchange rate away from the value implied by fundamentals. The bubble process is analogous to Bernanke and Gertler’s (1999) specification of an asset price bubble. We evaluate the performance of alternative simple monetary policy rules under both bubble and no-bubble scenarios and investigate whether policymakers should react to the deviation of the exchange rate from its steady-state value. The policy experiments employ a small-scale forward-looking structural model calibrated to UK data, which we previously used in Batini and Nelson (2000). For this model, which includes an uncovered interest parity condition, we find that the appropriate response to the exchange rate is captured by the expected inflation term, provided that the response coefficient and the inflation horizon are optimized. When uncovered interest parity is relaxed, there appears to be more merit in incorporating a separate exchange rate term in the monetary policy rule.

Keywords: Bubbles, monetary policy rules, foreign exchange market

JEL Classification: E52, E58

Suggested Citation

Batini, Nicoletta and Nelson, Edward, When the Bubble Bursts: Monetary Policy Rules and Foreign Exchange Market Behavior (October 24, 2000). Available at SSRN: https://ssrn.com/abstract=2899895 or http://dx.doi.org/10.2139/ssrn.2899895

Nicoletta Batini

International Monetary Fund (IMF) ( email )

700 19th Street NW
Washington, DC 20431
United States

Edward Nelson (Contact Author)

Federal Reserve Board ( email )

Federal Reserve Board
Division of Monetary Affairs
Washington, DC 20551
United States
2024522032 (Phone)

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