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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

  • Willem H. Buiter
  • Marcus Miller

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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This chapter was published in:
  • Georges de Ménil & Robert J. Gordon, 1991. "International Volatility and Economic Growth: The First Ten Years of The International Seminar on Macroeconomics," NBER Books, National Bureau of Economic Research, Inc, number de_m91-2, October.
  • This item is provided by National Bureau of Economic Research, Inc in its series NBER Chapters with number 11682.
    Handle: RePEc:nbr:nberch:11682
    Contact details of provider: Postal: National Bureau of Economic Research, 1050 Massachusetts Avenue Cambridge, MA 02138, U.S.A.
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    Web page: http://www.nber.orgEmail:


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    1. James Tobin, 1977. "How Dead is Keynes?," Cowles Foundation Discussion Papers 458, Cowles Foundation for Research in Economics, Yale University.
    2. 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, vol. 12(1), pages 293-355, January.
    3. Irving B. Kravis & Robert E. Lipsey, 1977. "Price Behavior in the Light of Balance of Payments Theories," NBER Working Papers 0181, National Bureau of Economic Research, Inc.
    4. Sargan, J D, 1980. "A Model of Wage-Price Inflation," Review of Economic Studies, Wiley Blackwell, vol. 47(1), pages 97-112, January.
    5. 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, vol. 45(179), pages 251-72, August.
    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.
    7. Willem H. Buiter & Marcus H. Miller, 1980. "Monetary Policy and International Competitiveness," NBER Working Papers 0591, National Bureau of Economic Research, Inc.
    8. 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.
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