Question

) Using the model of exchange rate determination presented in chapter 15, show how a permanent increase in the domestic money supply results in the exchange rate "overshooting" its long-run value. Label your initial equilibrium point on both graphs by A, the short-run equilibrium by B, and the long-run equilibrium by C. Would this overshooting occur if prices were flexible in the short-run? Explain.

Answer 1

PFA THE DIAGRAM BELOW.

Overshooting occurs because of difference in the speed of adjustment between the goods and money markets.

flexible exchange rate adjustment process involves a change in price. there are 2 strategic assumptions:

1) prices are rising whenever output exceeds employment level.

2) capital is perfectly mobile which means the external balance will be attained only when the domestic interest rate is equal to the foreign interest rate.

so, when there is a domestic money supply=> LM₁ shifts to the right i.e. LM₂ => i<i _f => outflow of capital => depreciation => net exports to rise => IS curve shifts to the right from IS₁ to IS₂

However, this is not the end as the output now is more than the full employment level (Y > Y^*) therefore, price level starts rising and real money supply decreases and LM curve shifts back to LM₁ . At the same time, at higher prices, net exports decrease and IS curve also shifts leftward to IS₁ . And the output returns from point C to point A. This was the long run scenario.

therefore, money supply leads to an immediate change in relative prices and competitiveness. it also involves exchange rate overshooting which means that SHORT RUN fluctuations in exchange rate is more than its LONG RUN fluctuations.

IF PRICES WERE FLEXIBLE, then this overshooting scenario wouldn't have occurred because prices would adjust instantaneously with the exchange rate. Overshooting occurs with sticky prices as prices do not adjust quickly, but the expectations of prices do.

null