Trend Inflation and Exchange Rate Dynamics
A New Keynesian Approach


This study examines the exchange rate implications of trend inflation within a two-country New Keynesian (NK) model. An NK Phillips curve generalized by trend inflation makes the inflation differential smoother, more persistent, and less sensitive to the real exchange rate. A Bayesian analysis with post-Bretton Woods data for Canada and the U.S. shows that the model’s equilibrium, which relies on Taylor rules with a persistent trend inflation shock and strong policy inertia, mimics empirical regularities in exchange rates that are difficult to reconcile within a standard NK model. Trend inflation helps explain the empirical puzzles of the exchange rate dynamics.

Report No.: HIAS-E-38
Author(s): Takashi Kano(a)
Affiliation: (a) Graduate School of Economics, Hitotsubashi University, Naka 2-1, Kunitachi, Tokyo 186-8601 Japan
Issued Date: December 2016
Revised February 2021
Keywords: Real and Nominal Exchange Rates, Trend Inflation, New Keynesian Models, Bayesian analysis
JEL: E31, E52, F31, and F41