Overshooting and Exchange Rate Disconnect Puzzle: A Reappraisal
AbstractTransitions to floating exchange rate regimes have led to sharp increases in exchange rate volatilities with no corresponding changes in the distribution of macroeconomic fundamentals. 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 a small open economy setting. With small adjustment costs on money holdings, overshooting substantially contributes to the nominal exchange rate volatility.
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Bibliographic InfoPaper provided by EconWPA in its series Macroeconomics with number 0410001.
Length: 33 pages
Date of creation: 01 Oct 2004
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Exchange rate disconnect puzzle; liquidity effect; overshooting; uncovered interest rate parity;
Find related papers by JEL classification:
- F31 - International Economics - - International Finance - - - Foreign Exchange
- F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
This paper has been announced in the following NEP Reports:
- NEP-ALL-2004-10-18 (All new papers)
- NEP-DGE-2004-10-18 (Dynamic General Equilibrium)
- NEP-IFN-2004-10-18 (International Finance)
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