Question

a) Explain what is meant by exchange rate overshooting/undershooting.

b) There are two (2) ways that authorities may try to finance increased government expenditure (G):

i. By printing extra money and using the money directly to finance its expenditure

ii. By borrowing — that is by selling bonds to economic agents

c) In the Dornbusch model the uncovered interest rate parity (UIP) condition is assumed to be hold continuously, that is, if the domestic interest rate is lower than the foreign interest rate then there need to be an equivalent expected rate of appreciation of the domestic currency to compensate for the lower domestic interest rate." Explain this statement.

Answer 1

a) Exchange rate overshooting essentially means the exchange rate fluctuates tremendously in the short run by either depreciating severely or appreciating as compared to how it performs in the long run. Thus whenever there is a change in the monetary policy the exchange rate fluctuates drastically whereas real goods prices remain sticky. For example if the foreign nominal interest rates are high, investors will demand foreign currency more and this will depreciate the domestic currency.

Exchange rate undershooting on the other hand means there is an appreciation or depreciation initially which is not so large and the gradual movement follows until the exchange rate reaches the stability level.

b) Both the options are true as printing more money will lead to investments and calibrated spread of money supply, if it is not calibrated that it will lead to extensive inflation. By borrowing the governments can repay the lenders after a long period of time as government bonds are considered safe for investment.

c) Uncovered interest rate parity assumes that return from a foreign asset will equate return from a domestic asset. Thus the prices of goods should be the same everywhere. Now if the domestic interest rates are lower, it means the domestic goods will be cheaper, for example 1EUR = 1USD. Now one has to pay 1 EUR in Europe for those goods where one only has to pay 0.9USD in US for the good. But the prices have to match, thus the domestic exchange rate will appreciate which means 1EUR will be 0.9USD, so that the good is priced at the same level. Thus the domestic currency appreciates to compensate for the lower domestic interest rate.