Central Bank Preferences and the Changing Nature of the Real Exchange Rate

This paper investigates the sources of real exchange rate fluctuations. We do so, first, in the context of a DSGE model that explicitly considers the central bank preferences. Then we estimate SVAR models, where shocks are... [ view full abstract ]

This paper investigates the sources of real exchange rate fluctuations. We do so, first, in the context of a DSGE model that explicitly considers the central bank preferences. Then we estimate SVAR models, where shocks are identified by the sign restrictions derived from the DSGE model, for twelve countries, of which nine have adopted inflation targeting during the period analyzed. In contrast to the previous evidence in the literature, we find that exchange rate (country risk premium) shocks have become the main drivers of real exchange rate dynamics, while real shocks play a less important role. Evidence from the DSGE model reveals that as the central bank becomes more averse to inflation movements and cares less about nominal exchange rate fluctuations, the impact of nominal shocks on the real exchange rate tends to increase, while the impact of real shocks decreases.