Title: Trend inflation and exchange rate dynamics: A new Keynesian approach
Authors: Takashi Kano - Hitotsubashi University (Japan) [presenting]
Abstract: Exchange rate implications of trend inflation are studied within a two-country new Keynesian model under incomplete international financial markets. A new Keynesian Phillips curve generalized by persistent variations in trend inflation with a positive long-run mean implies a second-order expectational difference equation of inflation rate in each country. A smoother and persistent process of the cross-country inflation differential as well as a slower moving dynamics of within-sector price dispersions leads to (i) a persistent real exchange rate with an autoregressive root close to one, (ii) a volatile real exchange rate relative to cross-country inflation differential, and (iii) an almost one-to-one comovement between real and nominal exchange rates within an otherwise standard two-country new Keynesian model. Trend inflation, therefore, approaches the persistence and volatility puzzles of exchange rates dynamics in actual data.