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Overshooting Meets Inflation Targeting

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  • Jose De Gregorio
  • Eric Parrado

Abstract

This paper revisits Dornbusch’s overshooting model; first, to discuss the conditions of overshooting and undershooting, extending the model to consider monetary policy rules and imperfect capital mobility. And second, to outline Dornbusch’s representation in the context of a simple dynamic neo-Keynesian model that can be used to analyze the impact of persistent changes in monetary policy, among other shocks. The model considers inflation targeting in a small open economy setup, which is characterized by imperfect competition and short-run price rigidity. The main findings of the paper are consistent with the original contribution where the exchange rate overshoots its long run equilibrium. We also show that flexible exchange rates dominate managed exchange rates in terms of output and inflation volatility in the presence of real shocks, while for nominal shocks the reverse is true.

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Bibliographic Info

Paper provided by Central Bank of Chile in its series Working Papers Central Bank of Chile with number 394.

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Date of creation: Dec 2006
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Handle: RePEc:chb:bcchwp:394

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  1. Lars E. O. Svensson, 2000. "Open-Economy Inflation Targeting," NBER Working Papers 6545, National Bureau of Economic Research, Inc.
  2. Maurice Obstfeld and Kenneth Rogoff., 1995. "Exchange Rate Dynamics Redux," Center for International and Development Economics Research (CIDER) Working Papers C95-048, University of California at Berkeley.
  3. Svensson, Lars E. O., 1999. "Inflation targeting as a monetary policy rule," Journal of Monetary Economics, Elsevier, vol. 43(3), pages 607-654, June.
  4. Cole, Harold L. & Obstfeld, Maurice, 1991. "Commodity trade and international risk sharing : How much do financial markets matter?," Journal of Monetary Economics, Elsevier, vol. 28(1), pages 3-24, August.
  5. Richard Clarida & Jordi Galí & Mark Gertler, 2000. "Monetary Policy Rules And Macroeconomic Stability: Evidence And Some Theory," The Quarterly Journal of Economics, MIT Press, vol. 115(1), pages 147-180, February.
  6. Jordi Gali & Tommaso Monacelli, 2002. "Monetary Policy and Exchange Rate Volatility in a Small Open Economy," NBER Working Papers 8905, National Bureau of Economic Research, Inc.
  7. Faust, Jon & Rogers, John H., 2003. "Monetary policy's role in exchange rate behavior," Journal of Monetary Economics, Elsevier, vol. 50(7), pages 1403-1424, October.
  8. Kenneth Rogoff, 2002. "Dornbusch's Overshooting Model After Twenty-Five Years," IMF Working Papers 02/39, International Monetary Fund.
  9. Lane, P, 1999. "The New Open Economy Macroeconomics: A Survey," Trinity Economics Papers 993, Trinity College Dublin, Department of Economics.
  10. Bennett T. McCallum & Edward Nelson, 2000. "Nominal Income Targeting in an Open-Economy Optimizing Model," NBER Working Papers 6675, National Bureau of Economic Research, Inc.
  11. Eichenbaum, Martin & Evans, Charles L, 1995. "Some Empirical Evidence on the Effects of Shocks to Monetary Policy on Exchange Rates," The Quarterly Journal of Economics, MIT Press, vol. 110(4), pages 975-1009, November.
  12. Maurice Obstfeld & Kenneth S. Rogoff, 1996. "Foundations of International Macroeconomics," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262150476, December.
  13. Blanchard, Olivier Jean & Kahn, Charles M, 1980. "The Solution of Linear Difference Models under Rational Expectations," Econometrica, Econometric Society, vol. 48(5), pages 1305-11, July.
  14. Richard Clarida & Jordi Gali & Mark Gertler, 1998. "Monetary policy rules in practice," Proceedings, Federal Reserve Bank of San Francisco, issue Mar.
  15. Giancarlo Corsetti & Paolo Pesenti, 2001. "Welfare And Macroeconomic Interdependence," The Quarterly Journal of Economics, MIT Press, vol. 116(2), pages 421-445, May.
  16. Tommaso Monacelli, 1999. "Into the Mussa Puzzle: Monetary Policy Regimes and the Real Exchange Rate in a Small Open Economy," Boston College Working Papers in Economics 437, Boston College Department of Economics, revised 15 Sep 2000.
  17. Dornbusch, Rudiger, 1976. "Expectations and Exchange Rate Dynamics," Journal of Political Economy, University of Chicago Press, vol. 84(6), pages 1161-76, December.
  18. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, vol. 12(3), pages 383-398, September.
  19. Meese, Richard A. & Rogoff, Kenneth, 1983. "Empirical exchange rate models of the seventies : Do they fit out of sample?," Journal of International Economics, Elsevier, vol. 14(1-2), pages 3-24, February.
  20. Jacob A. Frenkel & Carlos A. Rodriguez, 1982. "Exchange Rate Dynamics and the Overshooting Hypothesis," NBER Working Papers 0832, National Bureau of Economic Research, Inc.
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Cited by:
  1. Wieland, Volker, 2008. "Learning, Endogenous Indexation and Disinflation in the New-Keynesian Model," CEPR Discussion Papers 6749, C.E.P.R. Discussion Papers.
  2. Valdivia, Daney & Loayza, Lilian, 2010. "Adopción de metas de inflación y su impacto en las expectativas de inflación y volatilidad del crecimiento económico: evidencia empírica para Bolivia
    [Inflation targeting and its impact on the
    ," MPRA Paper 37328, University Library of Munich, Germany, revised 25 Aug 2011.

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