Expectations and Exchange Rate Dynamics

TLDR

The paper develops a theory of exchange rate movements under perfect capital mobility, slow goods‑market adjustment relative to asset markets, and consistent expectations. The model derives the perfect‑foresight path and quantifies the magnitude and persistence of overshooting in terms of structural parameters, assuming slow goods‑market adjustment. The analysis shows that a monetary expansion depreciates the exchange rate along the perfect‑foresight path, that overshooting arises from differential market speeds, and that output’s short‑run response dampens depreciation and can raise interest rates.

Abstract

The paper develops a theory of exchange rate movements under perfect capital mobility, a slow adjustment of goods markets relative to asset markets, and consistent expectations. The perfect foresight path is derived and it is shown that along that along that path a monetary expansion causes the exchange rate to depreciate. An initial overshooting of exchange rates is shown to derive from differential adjustment speed of markets. The magnitude and persistence of the overshooting is developed in terms of the structural parameters of the model. To the extent that output responds to a monetary expansion in the short run, this acts a a dampening effect on exchange depreciation and may, in fact, lead to an increase in interest rates.