The Role of the Exchange Rate in Monetary-Policy Rules

An important and still unsettled issue for monetary policy in open economies is how much of an interest-rate reaction there should be to the exchange rate in a monetary regime of a flexible exchange rate, an inflation target, and a monetary-policy rule. This paper endeavors to explain why monetary policy rules that react directly to the exchange rate do not work better by positing an indirect effect of exchange rates on interest rates. More research is needed to establish this advantage and to see if the findings hold up to more general measures of people's preferences, including perhaps the composition of output or the exchange rate itself.