Exchange Rate Undershooting

This paper reexamines the famous overshooting result derived by Dornbusch, which occurs when the economy is always operating at the level of full employment. When this assumption is abandoned and replaced with the more realistic assumption that output in the economy is variable but adjusts sluggishly, exchange rate undershooting can now occur. In this modified framework it remains true that asset markets adjust quickly but now both prices and real output adjust sluggishly. With sticky prices and output, monetary expansion causes interest rates to initially fall, just as in the Dornbusch model. However, contrary to the claim made by Dornbusch that the exchange rate necessarily overshoots when output adjusts sluggishly, the exchange rate may now either overshoot or undershoot. The intuitive explanation for undershooting is that monetary expansion causes the long-run equilibrium price level to rise, and this in turn may lead to the expectation that the domestic interest rate will rise. In that event, asset holders will expect the home currency to appreciate. However, if this expected appreciation is sufficiently strong, the home currency will have to undershoot to reduce the overall expected appreciation and maintain interest parity. Copyright @ 1999 by John Wiley & Sons, Ltd. All rights reserved.