Taylor rule equilibrium exchange rates and nonlinear mean reversion

This article analyses the validity of the Taylor rule exchange rate model from a new perspective. In a first step, a model-based exchange rate is derived for Germany and Japan following the approach by Engel and West (2006 Engel, C. and West, K. D. 2006. Taylor rules and the Deutschmark-Dollar real exchange rate. Journal of Money, Credit, and Banking, 38: 1175–94. [Crossref], [Web of Science ®] , [Google Scholar]). This model-based exchange rate is determined by the fundamentals of the Taylor rule exchange rate model and treated as the equilibrium exchange rate. Following this, exponential smooth transition regressive (ESTR) models are fitted to tackle the question of whether the real exchange rate shows mean reverting behaviour towards this equilibrium exchange rate. In particular for Germany, the results indeed suggest that real exchange rates adjust and mean revert much faster in case of large deviations from the equilibrium exchange rate.