Bubbles in exchange rates and monetary policy

Abstract

We evaluate the macroeconomic performance of different monetary policy rules when there are bubbles in the exchange rate. We do this in the context of a non-linear rational expectations model. The exchange rate is allowed to deviate from its fundamental value and the persistence of the deviation is modeled as a Markov switching process. Our results suggest that reacting to exchange rate movements does not significantly improve welfare. However, taking into account the switching nature of the economy may be more beneficial.