Do Exchange Rates Absorb Demand Shocks at the ZLB?

76 Pages Posted: 12 May 2021

Date Written: 2021

Abstract

According to the two-country full information New Keynesian model with flexible exchange rates, the real exchange rate appreciates in response to an asymmetric negative demand shock at the zero lower bound (ZLB) and exacerbates the adverse macroeconomic effects. This finding requires inflation expectations to adjust counterfactually large. When modeling inflation expectations consistent with survey expectations using imperfect information, we find that exchange rates can absorb demand shocks at the ZLB. In sharp contrast to the full information model: (i) A negative demand shock concentrated in the home country causes a real exchange rate depreciation that partially absorbs the demand shock. (ii) A VAR with an identified demand shock via sign restrictions is consistent with a real exchange rate depreciation at the ZLB. (iii) When the ZLB is binding in the home country, it is optimal for the foreign policymaker to reduce rather than increase foreign interest rates. (iv) Forward guidance that reveals the true state of the economy exacerbates the negative output gap in the two countries.

JEL Classification: F33, E31, E32

Suggested Citation

Hürtgen, Patrick and Hoffmann, Mathias, Do Exchange Rates Absorb Demand Shocks at the ZLB? (2021). Deutsche Bundesbank Discussion Paper No. 13/2021, Available at SSRN: https://ssrn.com/abstract=3844296 or http://dx.doi.org/10.2139/ssrn.3844296

Patrick Hürtgen (Contact Author)

Deutsche Bundesbank ( email )

Wilhelm-Epstein-Str. 14
Frankfurt/Main, 60431
Germany

Mathias Hoffmann

Deutsche Bundesbank ( email )

Wilhelm-Epstein-Str. 14
Frankfurt/Main, 60431
Germany

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