Taylor Rule Example
I was doing this example from Wiley´s QBank and I think they made a mistake in the correct answer. Could you please help me confirm that:
Give the following table, an analyst is asked to evaluate the direction of the domestic exchange rate relative to the country´s largest trading partner based on their central banks actions. The analyst decides to model the exchange rate movementes based on the Taylor rule
Date from the Central Banks:
Currency Policy Rate: 2.00% (Domestic) & 3.50% (Foreign)
Neutral Real Policy Rate: 2.50% (D) & 2.50% (F)
Current Inflation Rate: 0.00% (D) & 1.50% (F)
Target Inflation Rate: 2.00% (D) & 2.50% (F)
Current Output GAP: 1.00% (D) & -0.50% (F)
Assuming that the inflation mandate is weighted at 0.75 and the output mandate is weighted at 0.25, the most likely effect of monetary policy on the exchange rate is:
A. A depreciation of the domestic currency
B. An appreciation of the domestic currency
C. No change in the domestic exchange rate
I selected answer A but Wiley says the correct answer is B.
I checked their explanation and it says:
Use the Taylor rule to estimate the target interest rates for the domestic and foreign countries:
ld=2.50+0.00+0.75(0.00-2.00)+0.25(1.00) = 1.25%
lf=2.50+1.50+0.75(1.50-2.50)+0.25(-0.50) = 3.13%
Delta ld - Delta lf = (1.25-2.00) - (3.13-3.50) = -0.375
Since interest rates are expected to fall more in the domestic currency that in the foreign currency, capital will be expected to flow out of the domestic economy and into the foreign economy. The lower demand will put downward pressure on the domestic currency, thus causing it to depreciate against the foreign currency.
Do you agree that the correct answer should be A??
thanks for your help