THE OVERSHOOTING APPROACH Figure 15.1 indicates that with news regarding a higher trade deficit for

the domestic country, the spot exchange rate will jump immediately above E 0 and will then rise steadily until the new long-run equilibrium, E 1 , is reached. It is possible that the exchange rate may not always move in such an orderly fashion to the new long-run equilib-

Extensions to the Monetary Approach of Exchange Rate Determination 291

quickly. Dornbusch (1976) shows that the different speed of adjustment to equilibrium allows for some interesting behavior regarding exchange rates and prices.

At times it appears that spot exchange rates move too much, given some economic disturbance. Moreover, we have observed instances when country A has a higher inflation rate than country B, yet A’s currency appreciates relative to B’s. Such anomalies can be explained in the context of an “overshooting” exchange rate model. We assume that financial markets adjust instantaneously to an exogenous shock, whereas goods markets adjust slowly over time. With this setting, we analyze what happens when country A increases its money supply.

For equilibrium in the money market, money demand must equal money supply. Thus, if the money supply increases, something must happen to increase money demand. We assume money demand depends on income and the interest rate, so we can write a money demand func- tion like

ð15 :2Þ where M d is the real stock of money demanded (the nominal stock of

M d 5 aY 1 bi

money divided by the price level), Y is income, and i is the interest rate. Money demand is positively related to income, so a exceeds zero. As Y increases, people tend to demand more of everything, including money. Since the interest rate is the opportunity cost of holding money, there is an inverse relationship between money demand and i, or b is negative. It is commonly believed that in the short run following an increase in the money supply, both income and the price level are relatively constant. As a result, interest rates must drop to equate money demand to money supply.

The interest rate parity relation for countries A and B may be written as

i A 5i B 1 ðF 2 EÞ=E

ð15 :3Þ Thus, if i A falls, for a given foreign interest rate i B , the expected change

in the currency value, (F 2 E)/E, must be negative. However, when the money supply in country A increases, we expect that eventually prices

292 International Money and Finance

Since P A is expected to rise over time, given P B , E will also rise. This higher expected future spot rate will be reflected in a higher forward rate now. But if F rises, while at the same time (F

E)/E falls to maintain interest rate parity, E will have to increase more than F. Then, once prices start rising, real money balances fall and the domestic interest rate rises. Over time, as the interest rate increases, E will fall to maintain interest rate parity. Therefore, the initial rise in E will be in excess of the long-run E, or E will overshoot its long-run value.

If the discussion seems overwhelming at this point, the reader will be relieved to know that a concise summary can be given graphically. Figure 15.2 summarizes the discussion thus far. The initial equilibrium is

ate F 1 E 1 =F 1

E 0 ,F 0 Exchange r

Interest r

Extensions to the Monetary Approach of Exchange Rate Determination 293

given by E 0 ,F 0 ,P 0 , and i 0 . When the money supply increases at time t 0 , the domestic interest rate falls, and the spot and forward exchange rates increase while the price level remains fixed. The eventual equilibrium price and exchange rate will rise in proportion to the increase in the money supply. Although the forward rate will move immediately to its

new equilibrium, F 1 , the spot rate will increase above the eventual equilibrium, E 1 , because of the need to maintain interest parity (remem- ber i has fallen in the short run). Over time, as prices start rising, the interest rate increases and the exchange rate converges to the new

equilibrium, E 1 . As a result of the overshooting E, we observe a period where country

A has rising prices relative to the fixed price of country B, yet A’s currency appreciates along the solid line converging to E 1 . We might explain this period as one in which prices increase, lowering real money balances and raising interest rates. Country A experiences capital inflows in response to the higher interest rates, so that A’s currency appreciates steadily at the same rate as the interest rate increase in order to maintain interest rate parity.

THE OVERSHOOTING APPROACH Figure 15.1 indicates that with news regarding a higher trade deficit for