Abstract

Fiscal Policy and Exchange-Rate Overshooting

This paper demonstrates on the basis of a modified (Dornbusch 1976) model with real income levels determined by short-term demand and with a nominal monetary demand level dependent upon the consumer price index that substantial exchange rate fluctuations may be caused by fiscal impulses in both the long and the short terms. Exchange-rate overshooting in the short term occurs whenever the interest rate response is normal, i.e. when the level of domestic interest rises after a period of expansionary fiscal policy. It is shown that the long-term exchange rate effects of an expansionary fiscal policy course depend strongly on the respective combination of structural parameters. These effects have hitherto been neglected in the analyses made, which focused exclusively on the short-term fluctuations around an equilibrium value not yet examined in detail. It is also demonstrated that there may be a tradeoff between the short-term and the long-term exchange-rate variability under certain circumstances.