Contents

This paper examines how much the central bank should adjust the interest rate in response to real exchange rate fluctuations in a two-country Dynamic Stochastic General Equilibrium (DSGE) model. The model can duplicate the major real business cycle statistics observed in the data and is the first DSGE model to study the role of home bias in consumption in explaining the exchange rate disconnect puzzle. A second-order accurate solution method is employed to solve the model and compare the con-ditional 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 offers a new solution to the exchange rate disconnect puzzle, namely home bias in consumption. When home bias is high, the shock to Uncovered Interest-rate Parity (UIP) can substan-tially 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 tha