Working Paper Series,
Uppsala University, Department of Economics

Abstract: We argue that it is not necessary for the central bank to react to the exchange rate to have a desirable outcome in the economy. Indeed, when the Taylor rule includes contemporaneous data on the variables in the rule, the central bank can disregard from the exchange rate as long as there is enough with interest rate inertia in monetary policy. The reason is that interest rate inertia and a reaction to the current nominal exchange rate change are perfect substitutes in monetary policy. Hence, we give a rationale for the central bank to focus on the interest rate change rather than the interest rate level to have a desirable outcome in the economy, which we define as a determinate rational expectation equilibrium that is stable under least squares learning.

Keywords: Determinacy; Foreign Exchange; Interest Rate Inertia; Least Squares Learning; Monetary Policy; Taylor Rule

JEL-codes: E52; F31

33 pages, October 19, 2011

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