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

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Author Info
Willem H. Buiter
Marcus H. Miller

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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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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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Handle: RePEc:nbr:nberwo:0749

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References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. Willem H. Buiter & Marcus H. Miller, 1982. "Monetary Policy and International Competitiveness," NBER Working Papers 0591, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  2. 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.
  3. James Tobin, 1977. "How Dead is Keynes?," Cowles Foundation Discussion Papers 458, Cowles Foundation, Yale University. [Downloadable!]
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  4. Sargan, J D, 1980. "A Model of Wage-Price Inflation," Review of Economic Studies, Blackwell Publishing, vol. 47(1), pages 97-112, January. [Downloadable!] (restricted)
  5. Kravis, Irving B. & Lipsey, Robert E., 1978. "Price behavior in the light of balance of payments theories," Journal of International Economics, Elsevier, vol. 8(2), pages 193-246, May. [Downloadable!] (restricted)
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  6. 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. [Downloadable!] (restricted)
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