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The Exchange Rate-Investment Nexus and Exchange Rate Instability: Another Reason for 'Fear of Floating'

  • Habib Ahmed

    (Islamic Development Bank)

  • C. Paul Hallwood

    (University of Connecticut)

  • Stephen M. Miller

    (University of Connecticut and University of Nevada, Las Vegas)

We show that expansionary monetary policy causes exchange rate overshooting due to the secondary repercussion comes through the reaction of firms to changed asset prices and the firms' decisions to invest in real capital. This overshooting effect adds to any overshooting that occurs through the traditional Dornbusch (1976) channel, since our model with its market clearing in the short run excludes any Dornbusch overshooting. The model sheds further light on the volatility of real and nominal exchange rates. It suggests that changes in corporate sector profitability may affect exchange rates through international portfolio diversification in corporate securities, and it offers an additional reason for 'fear of floating'.

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Paper provided by University of Connecticut, Department of Economics in its series Working papers with number 2006-15.

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Date of creation: Jun 2006
Date of revision: Jan 2009
Publication status: Published in Keio Economic Studies, 2008.
Handle: RePEc:uct:uconnp:2006-15
Note: This paper previously circulated under the title "Monetary Policy, Exchange Rate Overshooting, and Endogenous Physical Capital".
Contact details of provider: Postal: University of Connecticut 365 Fairfield Way, Unit 1063 Storrs, CT 06269-1063
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