Question

In previous discussion of short-run exchange rate overshooting, we assumed real output was fixed. Assume instead that an increase in the money supply raises real output in the short run. a) How does this affect the extent to which the exchange rate overshoots in the short run? (1 mark) b) Is it likely that the exchange rate undershoots (relative to its long run value) in the short run? Explain. (1 mark) c) Explain with the help of a figure, the transition to long run equilibrium if the exchange rate overshoots relative to its long run value. (1.5 mark) d) Explain with the help of a figure, the transition to long run equilibrium if the exchange rate undershoots relative to its long run value. (1.5 mark) Note: Undershooting is when the spot exchange rate in the short run is less than the exchange rate in the long-run (Elr)

Answer 1

If the rise in money supply from Mo/Po to M₁/Po leads to a short run increase in real output, then the money demand function will shift outward from Lo to L₁. The real rate of interest falls to R₁ instead of R₁^'. Since the interest rate does not fall as much when output rises, the exchange rate depreciates by less, as compared to if the real output was fixed. the exchange increasing from its initial value of E₀ to E₁, rather than to E₁^' . In the long run, prices change and the real money supply falls to the original level such that M₁/P₁ is equal to Mo/Po. Interest rate rises to R2 but the the exchange rate appreciates to E₂ in the long run.

b) Undershooting of exchange rate occurs if the new short-run exchange rate (E₁) is initially below its new long-run level (E₂). This happens only if the interest rate rises when the money supply rises, that is, if output increases so much that interest rate also increases. This can't be possible because the rise in money supply leads to a rise in real output by reducing interest rates. the change in output is not expected to be high enough to increase interest rate.

c) The transition diagram is as follows in case of exchange rate overshooting

The transition path indicates that the exchange rate overshoots its long-run value (E₁ < E₂), the interest rate rises to R₂ and prices rise from Po to P₁ as much as the money supply increase to make real money balances remain unchanged.

d) The transition to long run equilibrium if the exchange rate undershoots relative to its long run value is depicted below:

The transition path indicates that the exchange rate undershoots its long-run value (E₂ < E₃), because of the fall in interest rate and prices fall as much as the money supply decrease to make real money balances remain unchanged.