Exchange rate dynamics in a Taylor rule framework

Abstract

This paper establishes a dynamic exchange rate determination model incorporating capital control and foreign exchange intervention in a Taylor rule framework. It uses the SVAR model to identify the sources of real exchange rate dynamics for three pairs of currencies: RMB/USD, Yen/USD and GBP/USD. It shows that demand shock, instead of supply shock, plays a dominant role in real exchange determination. Monetary policy has little effect but central bank intervention plays a role in keeping exchange rate persistence for RMB/USD and Yen/USD. Risk premium shock is almost irrelevant to exchange rate dynamics for Yen/USD and GBP/USD. In the case of China, capital control plays a critical role in exchange rate determination. The results show that social welfare losses of China is the largest, suggesting that capital account liberalization would benefit the country in the long term. Therefore, the central bank of China should gradually open up the capital account, give up the fixed exchange rate or the managed floating exchange rate regime, and reduce central bank intervention to improve the effectiveness of monetary policy and social welfare.