Supply Shocks, Price Regime Collapse under Dual Floating Exchange Rate Regimes

This paper extends the theoretical model of Liaw et al. (2004) to incorporate the supply shocks of output. For a country adopting dual floating exchange rate system and facing the supply shocks will cause the price level to increase persistently. If the price level reaches the price ceiling threshold, then the monetary authority will adopt deflationary policy. It is wondered how these shocks will affect the possible adjustment paths of relevant macroeconomic variables. The major findings are as follows. The liquidity effect, foreign interest revenue effect and interest rate income effect which are all caused by change in the nominal money supply are the key factors affecting the possible adjustment paths of relevant macroeconomic variables. Moreover, whether the price regime will collapse or not and the timing of the monetary authority will adjust nominal money supply are dependent on the price ceiling threshold. The stronger the desire of the monetary authority to defend the price ceiling threshold, the earlier the monetary authority will adopt the monetary policy to attack inflation.