2006) “Taylor Rules and the Deutschmark-Dollar Real Exchange Rate

We explore the link between an interest rate rule for monetary policy and the behavior of the real exchange rate. The interest rate rule, in conjunction with some standard assumptions, implies that the deviation of the real exchange rate from its steady state depends on the present value of inflation and output gap differentials. An initial look at German data yields some support for the model. We thank the National Science Foundation for financial support, Jeffrey Frankel, Hélène Rey, and participants in various seminars for helpful comments, and Shiu-Sheng Chen, Akito Matsumoto and Yu Yuan for research assistance. This paper was revised while West was a Houblon-Norman Fellow at the Bank of England. This paper explores the link between an interest rate rule for monetary policy and the behavior of the real exchange rate. A large body of research has studied the connection between monetary policy or interest rates on the one hand and exchange rates on the other. The vintage monetary model of the exchange rat