Trend Inflation and Exchange Rate Dynamics: A New Keynesian Approach

The paper studies exchange rate implications of trend inflation within a two-country New
Keynesian (NK) model under incomplete international financial markets. A NK Phillips
curve generalized by trend inflation with a positive long-run mean implies an
expectational difference equation of inflation with higher-order leads of expected
inflation. The resulting two-country inflation differential is smoother, more persistent, and
more insensitive to a real exchange rate. General equilibrium then yields (i) a persistent
real exchange rate with an autoregressive root close to one, (ii) a hump-shaped impulse
response of a real exchange rate with a half-life longer than four years, (iii) a volatile real
exchange rate relative to cross-country inflation differential, (iv) an almost perfect comovement
between real and nominal exchange rates and (v) a sharp rise in the volatility
of a real exchange rate from a managed nominal exchange rate regime to a flexible one
within an otherwise standard two-country NK model. Trend inflation, therefore,
approaches empirical puzzles of exchange rates dynamics.