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Overshooting and the exchange rate disconnect puzzle: a reappraisal

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  • Hairault, Jean-Olivier
  • Patureau, Lise
  • Sopraseuth, Thepthida

Abstract

Transition to floating exchange rate regimes has led to sharp increases in nominal and real exchange rate volatilities with no corresponding changes in the distribution of fundamental macroeconomic variables. In the spirit of Dornbusch [1976], we assess whether nominal exchange rate overshooting is responsible for this phenomenon. As long as uncovered interest rate parity holds, nominal exchange rate overshooting is linked to a persistent fall in the spread between domestic and foreign nominal interest rates. We thus develop a limited participation model in an international setting. Introducting adjustment costs on money holdings in the limited participation framework substantially raises the magnitude of the overshooting dynamics. Overshooting indeed plays a key role in understanding the extreme nominal exchange rate volatility.

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Paper provided by CEPREMAP in its series CEPREMAP Working Papers (Couverture Orange) with number 0305.

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Length: 33 pages
Date of creation: 2003
Date of revision:
Handle: RePEc:cpm:cepmap:0305

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Cited by:
  1. de Blas, Beatriz, 2010. "Exchange rate dynamics in economies with portfolio rigidities," International Review of Economics & Finance, Elsevier, vol. 19(3), pages 366-382, June.
  2. Kollmann, Robert, 2002. "Monetary Policy Rules in the Open Economy: Effects on Welfare and Business Cycles," CEPR Discussion Papers 3279, C.E.P.R. Discussion Papers.
  3. Patureau, Lise, 2007. "Pricing-to-market, limited participation and exchange rate dynamics," Journal of Economic Dynamics and Control, Elsevier, vol. 31(10), pages 3281-3320, October.
  4. Lise Patureau, 2002. "Pricing-to-market and limited participation : a joint explanation to the exchange rate disconnect puzzle," Computing in Economics and Finance 2002 299, Society for Computational Economics.
  5. Murphy, Austin, 2008. "An empirical investigation of investor expectations in the currency market," International Review of Financial Analysis, Elsevier, vol. 17(1), pages 108-133.
  6. Murphy, Austin & Zhu, Yun (Ellen), 2008. "Unraveling the complex interrelationships between exchange rates and fundamentals," Journal of Banking & Finance, Elsevier, vol. 32(6), pages 1150-1160, June.
  7. Kollmann, Robert, 2003. "Monetary Policy Rules in an Interdependent World," CEPR Discussion Papers 4012, C.E.P.R. Discussion Papers.
  8. Karamé, Frédéric & Patureau, Lise & Sopraseuth, Thepthida, 2008. "Limited participation and exchange rate dynamics: Does theory meet the data?," Journal of Economic Dynamics and Control, Elsevier, vol. 32(4), pages 1041-1087, April.

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