The Taylor Rule

The future movement of an exchange rate is being forecast. Based on estimated price level changes, purchasing power parity suggests that the exchange rate will rise. If central banks will choose policy rates according to the Taylor rule, the exchange rate will most likely:

Correct! Since purchasing power parity suggests that the exchange rate will rise, policymakers will choose future nominal rates according to these same expectations. The changes in real rates will then pull the exchange rate in exactly the opposite direction suggested by purchasing power parity.

Incorrect. Purchasing power parity suggests that the rate will rise, but policymakers will use this same information about expected inflation differentials to choose future real rates.

Incorrect. Based on just the information given, a clear direction for the exchange rate can be forecast.

fall.

rise.

be pushed in both directions with an ambiguous result.