Exchange Rate Overshooting

Exchange Rate Overshooting - must also fall. If correct...

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Exchange Rate Overshooting Exchange rate overshooting occurs when speculators rationally react to news of a change in economic policy by driving the exchange rate past what they know will be its ultimate equilibrium. Suppose there is a 10% increase in the U.S. money supply. The value of the dollar will fall by 10% in the long run as the domestic price level rises by 10%. However, prices are sticky, so it takes time for prices to rise 10%. r f /r s = (1 + i)/(1 + i for ) A rise in the money supply will cause domestic interest rates to fall, making foreign investment more attractive. Now, covered interest parity does not hold. The left-hand side of the equation
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Unformatted text preview: must also fall. If correct speculation makes r f go up by 10%, then r s must go up by more than 10% to keep CD = 0. Speculators must have the prospect of seeing the value of the dollar rise in order to keep them invested in the U.S. This can only happen if the value of the dollar is bid below its ultimate value. Foreign Exchange Policies 1. intervene in the foreign exchange market 2. impose direct restrictions on international transactions 3. adopt tighter aggregate demand policies 4. allow the exchange rate to adjust exchange rate regimes 1. gold standard 2. Bretton Woods 3. flexible exchange rates...
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This note was uploaded on 11/22/2011 for the course FIN FIN1100 taught by Professor Bradrifkin during the Fall '09 term at Broward College.

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Exchange Rate Overshooting - must also fall. If correct...

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