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Real Exchange Rate Overshooting and the Output Cost of Bringing Down Inflation

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  • Willem H. Buiter
  • Marcus H. Miller

Abstract

Implementing a 'gradualist' policy of monetary contraction, in an open economy with a freely floating exchange rate but with nominal inertia in domestic labor costs, can lead to prompt and substantial changes in the nominal and real exchange rate. One of the virtues claimed for such exchange rate 'overshooting', however, is its immediate effect on the price level and so on domestic wage and price inflation. In this paper we show that, in a model which is 'super-neutral' and has nominal inertia in both the level of labor costs and their trend or core rate of growth, this early overshooting of the exchange rate does not succeed in cutting the output costs of reducing steady-state inflation. Those output and unemployment costs which are initially avoided by over- valuing the currency have to be paid later when this overvaluation is corrected. Relative to other policies which achieve the same effect on steady-state inflation, exchange rate overshooting brings inflation down more quickly.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 0749.

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Date of creation: Oct 1982
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Publication status: published as Buiter, Willem H. and Miller, Marcus. "Real Exchange Rate Overshooting and the Output Cost of Bringing Down Inflation." European Economic Review, Vol. 18, No.1, 1982, pp.85-123.
Handle: RePEc:nbr:nberwo:0749

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  1. Sargan, J D, 1980. "A Model of Wage-Price Inflation," Review of Economic Studies, Wiley Blackwell, vol. 47(1), pages 97-112, January.
  2. Minford, Patrick, 1980. "A rational expectations model of the United Kingdom under fixed and floating exchange rates," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 12(1), pages 293-355, January.
  3. Isard, Peter, 1977. "How Far Can We Push the "Law of One Price"?," American Economic Review, American Economic Association, vol. 67(5), pages 942-48, December.
  4. Liviatan, Nissan, 1980. "Anti-Inflationary Monetary Policy and the Capital Import Tax," The Warwick Economics Research Paper Series (TWERPS) 171, University of Warwick, Department of Economics.
  5. Buiter, Willem H, 1978. "Short-run and Long-run Effects of External Disturbances under a Floating Exchange Rate," Economica, London School of Economics and Political Science, vol. 45(179), pages 251-72, August.
  6. Irving B. Kravis & Robert E. Lipsey, 1977. "Price Behavior in the Light of Balance of Payments Theories," NBER Working Papers 0181, National Bureau of Economic Research, Inc.
  7. Willem H. Buiter & Marcus H. Miller, 1980. "Monetary Policy and International Competitiveness," NBER Working Papers 0591, National Bureau of Economic Research, Inc.
  8. James Tobin, 1977. "How Dead is Keynes?," Cowles Foundation Discussion Papers 458, Cowles Foundation for Research in Economics, Yale University.
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