Working Paper: NBER ID: w0749
Authors: 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.
Keywords: exchange rate; inflation; monetary policy; overshooting; output costs
JEL Codes: E31; E52; F31
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Restrictive monetary policy (E52) | Nominal appreciation of the currency (F31) |
| Nominal appreciation of the currency (F31) | Real appreciation (Y60) |
| Real appreciation (Y60) | Decline in output below capacity levels (E23) |
| Exchange rate overshooting (F31) | Decline in domestic price levels (E31) |
| Decline in domestic price levels (E31) | Temporary decline in inflation (E31) |
| Initial appreciation (Y20) | Avoidance of output and unemployment costs (J65) |
| Currency overvaluation (F31) | Compensation later when overvaluation is corrected (J33) |
| Overshooting (Y60) | Redistribution of early gains over time (D15) |
| Output costs incurred (D22) | Restoration of competitiveness (F12) |