Exchange Rates, Expectations, and Monetary Policy: a NOEM Perspective*

Abstract We use a dynamic general‐equilibrium optimizing two‐country model to analyze how the formation of exchange rate expectations shapes the effects of a monetary policy shock in an open economy. We also provide empirical evidence on how traders in foreign exchange markets form exchange rate expectations. Our model implies that the short‐run output effect of a permanent monetary policy shock diminishes if “technical traders” form the type of regressive exchange rate expectations we find in our empirical analysis. If the influence of technical traders is strong enough, a permanent expansionary monetary policy shock can result in a temporary decline of the output in the country in which it takes place. The output effect of a temporary monetary policy shock is magnified when technical traders form regressive exchange rate expectations.