The Real Exchange Rate in Taylor Rules: A Re-Assessment

Abstract

Examining three flexible inflation targeting strategies, we find that a small concern for real exchange rate stability as a policy goal matters. First, it warrants the inclusion of the real exchange rate in Taylor rules and, second, it is sufficient to improve the performance of Taylor rules relative to optimal policy. Gains are substantial for domestic and REX inflation targets because a small weight on real exchange rate fluctuations makes optimal policy less aggressive. The gains under CPI inflation targeting are considerably lower.