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Overshooting and Exchange Rate Disconnect Puzzle: A Reappraisal

  • Jean-Olivier Hairault


  • Lise Patureau


  • Thepthida Sopraseuth


Transitions to floating exchange rate regimes have led to sharp increases in exchange rate volatilities with no corresponding changes in the distribution of macroeconomic fundamentals. In the spirit of Dornbusch (1976), we assess whether nominal exchange rate overshooting is responsible for this phenomenon. As long as uncovered interest rate parity holds, nominal exchange rate overshooting is linked to a persistent fall in the spread between domestic and foreign nominal interest rates. We thus develop a limited participation model in a small open economy setting. With small adjustment costs on money holdings, overshooting substantially contributes to the nominal exchange rate volatility.

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Paper provided by EconWPA in its series Macroeconomics with number 0410001.

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Length: 33 pages
Date of creation: 01 Oct 2004
Date of revision:
Handle: RePEc:wpa:wuwpma:0410001
Note: Type of Document - pdf; pages: 33
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