Existing literature often views exchange rate policy as a static problem which can be analyzed with single-period models, under the assumption that prices are flexible and the economy will return to equilibrium next period. In reality, exchange rate policy is an on-going operation conducted while the economy is in disequilibrium. This thesis adopts such a dynamic perspective. Using a sticky-price, rational expectation monetary model, I derive the disequilibrium dynamics of the economy using the technique proposed by Blanchard and Kahn. The behavior of the economy is examined under alternative formulation of reaction functions of the monetary authority. Given the stochastic processes followed by the fundamentals, endogenous variables are simulated and characterized in terms of three dynamic features. The first is the persistence of disequilibrium dynamics. Another is volatility which is measured by conditional variance. The last feature is the amplitude of deviations from equilibrium which is measured by unconditional variance. The reaction functions studied include equilibrium nominal exchange rate targeting (DE), interest rate differential targeting (IT), exchange rate smoothing (AC), and inflation targeting (PT). Several general conclusions are reached. (1) There exists a trade off between persistence and volatility. Policy rules can reduce one at the expense of increasing the other. The trade off hinders policymaker's ability to influence the amplitude of real exchange rate and output gaps. (2) Some policies generate trade offs between the dynamic features among different variables. For example, the AC policy reduces the volatility of the exchange rate while increasing that of the interest rates. (3) The volatility and amplitude of some endogenous variables exhibit nonmonotonic behavior with respect to the degree of intervention. (4) Only the PT can insulate domestic country from foreign shocks. It complements the DE and IT policies. (5) The AC policy tends to interfere with other policies abroad and can be destabilizing. (6) The DE and IT policies generate similar dynamic patterns and are effective in reducing the volatilities of the interest rates. (7) Finally, correlations between domestic and foreign shocks only affect volatility but has little effect on persistence dynamics and the patterns generated by various policy reaction combinations of both countries.
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