Dear all, would someone be so kind to explain or tell me where to read a good explanation of why:
“An increase in the inflation gap in the euro area relative to the inflation gap in the US will strengthen the euro versus the USD in real terms”
and
“An increase in the output gap in the euro area relative to the output gap in the US will strengthen the euro versus the USD in real terms”
Thanks!
It is all related to the Taylor rule which is a simplified prediction of central bank policy. The short story is, that the Economist John B. Taylor estimated a regression equation that did a very good job of describing how central banks set their interest rates:
i=r+pi+alpha(pi-pi*)+beta(y-y*)
pi* and y* are the target inflation rate and potential output.
If you insert your inflation gap and output gap in there, you will see happens to the interest rates.
From there you can determine the effect on exchange rates based on: higher interest rate will lead to appreciation and vice versa.
Thanks! Indeed!
You’re very welcome.