Trend Inflation and Exchange Rate Dynamics : A New Keynesian Approach

First Draft : February 15, 2016. Current Draft : April 26, 2023.
This study examines the exchange rate implications of trend inflation within a two-country New Keynesian (NK) model. An NK Phillips curve generalized by trend inflation makes the inflation differential smoother, more persistent, and less sensitive to the real exchange rate. A Bayesian analysis with post-Bretton Woods data for Canada and the U.S. shows that the model’s equilibrium, which relies on Taylor rules with a persistent trend inflation shock and strong policy inertia, mimics empirical regularities in exchange rates that are difficult to reconcile within a standard NK model. Trend inflation helps explain the empirical puzzles of the exchange rate dynamics.
Grant-in-aid for scientific research from the Japan Society for the Promotion of Science (numbers 17H02542 and 17H00985)