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If Exchange Rates Are Random Walks, Then Almost Everything We Say About Monetary Policy Is Wrong

Fernando Alvarez - Consultant
Andrew Atkeson - Consultant
Patrick J. Kehoe - Consultant

Published June 18, 2008

Abstract
The key question asked by standard monetary models used for policy analysis is, 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.


Reprinted From: AEA Papers and Proceedings (Vol. 97, May 2007, pp. 339-345)

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