Home Bias, Exchange Rate Disconnect, and Optimal Exchange Rate Policy

44 Pages Posted: 13 Mar 2007

See all articles by Jian Wang

Jian Wang

The Chinese University of Hong Kong, Shenzhen; Shenzhen Finance Institute

Date Written: January 2007

Abstract

This paper examines how much the central bank should adjust the interest rate in response to real exchange rate fluctuations. The paper first demonstrates in a two-country Dynamic Stochastic General Equilibrium (DSGE) model, that the home bias in consumption is important to duplicate the exchange rate volatility and exchange rate disconnect documented in the data. When home bias is high, the shock to Uncovered Interest-rate Parity (UIP) can substantially drive up exchange rate volatility while leaving the volatility of real macroeconomic variables, such as GDP, almost untouched. The model predicts the volatility of the real exchange rate relative to that of GDP increases with the extent of home bias. This relation is strongly supported by the data. Then a second-order accurate solution method is employed to solve the model and compare the conditional welfare under different policy regimes. The results suggest that the monetary authority should not seek to vigorously stabilize exchange rate fluctuations. In particular, when the central bank does not take a strong stance against the inflation rate, exchange rate stabilization may induce substantial welfare loss. The model also suggests no welfare gain from the international monetary cooperation, which extends Obstfeld and Rogoff's (2002) findings to a DSGE model.

Keywords: Home bias, Exchange rate volatility, Exchange rate disconnect, Optimal monetary policy

JEL Classification: E52, F31, F41

Suggested Citation

Wang, Jian, Home Bias, Exchange Rate Disconnect, and Optimal Exchange Rate Policy (January 2007). Federal Reserve Bank of Dallas Working Paper No. 0701. Available at SSRN: https://ssrn.com/abstract=969890 or http://dx.doi.org/10.2139/ssrn.969890

Jian Wang (Contact Author)

The Chinese University of Hong Kong, Shenzhen ( email )

HOME PAGE: http://jianwang.weebly.com

Shenzhen Finance Institute ( email )

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