Working Paper: NBER ID: w1195
Authors: David H. Papell
Abstract: After a decade of generalized floating, it is clear that bilateral exchange rates exhibit more variability than the economic aggregates; relative prices, incomes, and money supplies, that generally comprise the fundamentals of theories of exchange rate determination. Dornbush's over-shooting hypothesis is the best known explanation of this phenomenon. This paper shows that accommodative monetary policy (with respect to prices) has the potential to cause the economy to switch from exchange rate overshooting to undershooting. Using constrained maximum likelihood methods, the model is estimated for Germany and the United States. The results provide strong evidence in support of the overshooting hypothesis for the Deutsche Mark/Dollar exchange rate.
Keywords: Monetary Policy; Exchange Rates; Overshooting; Deutsche Mark; Dollar
JEL Codes: E52; F31
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| activist monetary policy (E63) | exchange rate behavior (F31) |
| accommodative monetary policy (E52) | switch from exchange rate overshooting to undershooting (F31) |
| responsive money supply (E51) | exchange rate overshooting (F31) |
| exchange rate overshooting (F31) | new steady state (C62) |
| less accommodative U.S. monetary policy (E49) | increase in overshooting of exchange rate (F31) |
| lack of responsiveness of monetary policy to prices (E39) | exchange rate overshooting (F31) |