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

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  • Buiter, Willem H
  • Miller, Marcus

    (University of Warwick)

Abstract

The proposition that under a floating exchange rate regime restrictive monetary policy can lead to substantial "overshooting" of the nominal and real exchange rate is now accepted fairly widely. The fundamental reason is the presence of nominal stickiness or inerta in domestic factor and product markets combined with a freely flexible nominal exchange rate. Current and anticipated future monetary policy actions are reflected immediately in the nominal exchange rate, set as it is in a forward-looking efficient auction market while they are reflected only gradually and with a lag in domestic nominal labour costs and / or goods prices. Nominal appreciation of the currency therefore amounts to real appreciation - a loss of competitivensss. Since in most of the simple analytical models used to analyse the overshooting propositions there is no long-run effect of monetary policy on the real exchange rate, any short-run real appreciation implies an overshooting of the long-run equilibrium. The transitory (but potentially quite persistent) loss of competitiveness is associated with a decline in output below its capacity level. This excessive capacity is one of the channels through which restrictive monetary policy brings down the rate of domestic cost and price inflation.

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Bibliographic Info

Paper provided by University of Warwick, Department of Economics in its series The Warwick Economics Research Paper Series (TWERPS) with number 204.

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Length: 58 pages
Date of creation: 1981
Date of revision:
Handle: RePEc:wrk:warwec:204

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  1. Willem H. Buiter & Marcus H. Miller, 1980. "Monetary Policy and International Competitiveness," NBER Working Papers 0591, National Bureau of Economic Research, Inc.
  2. Isard, Peter, 1977. "How Far Can We Push the "Law of One Price"?," American Economic Review, American Economic Association, American Economic Association, vol. 67(5), pages 942-48, December.
  3. Sargan, J D, 1980. "A Model of Wage-Price Inflation," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 47(1), pages 97-112, January.
  4. 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, Elsevier, vol. 12(1), pages 293-355, January.
  5. Liviatan, Nissan, 1980. "Anti-Inflationary Monetary Policy and the Capital Import Tax," The Warwick Economics Research Paper Series (TWERPS), University of Warwick, Department of Economics 171, University of Warwick, Department of Economics.
  6. Kravis, Irving B. & Lipsey, Robert E., 1978. "Price behavior in the light of balance of payments theories," Journal of International Economics, Elsevier, Elsevier, vol. 8(2), pages 193-246, May.
  7. 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, London School of Economics and Political Science, vol. 45(179), pages 251-72, August.
  8. James Tobin, 1977. "How Dead is Keynes?," Cowles Foundation Discussion Papers, Cowles Foundation for Research in Economics, Yale University 458, Cowles Foundation for Research in Economics, Yale University.
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