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

In: International Volatility and Economic Growth: The First Ten Years of The International Seminar on Macroeconomics

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  • Willem H. Buiter
  • Marcus 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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Suggested Citation

  • Willem H. Buiter & Marcus Miller, 1991. "Real Exchange Rate Overshooting and the Output Cost of Bringing Down Inflation," NBER Chapters, in: International Volatility and Economic Growth: The First Ten Years of The International Seminar on Macroeconomics, pages 239-277, National Bureau of Economic Research, Inc.
    • Handle: RePEc:nbr:nberch:11682
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    References listed on IDEAS

    as
    1. Buiter, Willem H. & Miller, Marcus, "undated". "Monetary Policy And International Competitiveness," Economic Research Papers 269135, University of Warwick - Department of Economics.
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    JEL classification:

    • H55 - Public Economics - - National Government Expenditures and Related Policies - - - Social Security and Public Pensions
    • I20 - Health, Education, and Welfare - - Education - - - General
    • D91 - Microeconomics - - Micro-Based Behavioral Economics - - - Role and Effects of Psychological, Emotional, Social, and Cognitive Factors on Decision Making

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