Abstract

Demand Shocks and Exchange Rate Volatility

This paper analyzes a model of a small open economy with flexible exchange rates in which the production potential responds to changes in the real rate of exchange. Otherwise, the model conforms to the standard theory monetary exchange rate approach. The dependence of the level of output on the real exchange rate leads to a situation in which non-monetary shocks, which cannot be absorbed by suitable changes in the nominal exchange rate, unleash adjustment processes over time. It has been demonstrated on the basis of fiscal expansion that the real rate of exchange unambiguously overshoots its long-term equilibrium value; this is associated with a temporary rise of the domestic level of real interest rates above the world market level. The shape of the adjustment processes is not unambiguous for the nominal quantities. Any overshooting of the nominal exchange rate presupposes a sufficiently weak response of the trade balance at a correspondingly slow pace of adjustment of the domestic goods price level. With high price flexibility, however, overshooting will be the result.