Staff Report 388

If Exchange Rates Are Random Walks, Then Almost Everything We Say about Monetary Policy is Wrong

Patrick J. Kehoe | Stanford University, University College London, Federal Reserve Bank of Minneapolis
Andrew Atkeson | Consultant
Fernando Alvarez | Consultant

Published March 1, 2007

The key question asked by standard monetary models used for policy analysis, How do changes in short-term interest rates affect the economy? All of the standard models imply that such changes in interest rates affect the economy by altering the conditional means of the macroeconomic aggregates and have no effect on the conditional variances of these aggregates. We argue that the data on exchange rates imply nearly the opposite: the observation that exchange rates are approximately random walks implies that fluctuations in interest rates are associated with nearly one-for-one changes in conditional variances and nearly no changes in conditional means. In this sense standard monetary models capture essentially none of what is going on in the data. We thus argue that almost everything we say about monetary policy using these models is wrong.

Published In: American Economic Review (Vol. 97, No. 2, May 2007, pp. 339-345)

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