Question

1. Use an equation in the long run to determine the movement of the Japanese exchange rate, Eyen/$ (home country: Japan)

2. Explain why “overshooting” occurs in the short tun, but not in the long run (note: your discussion must follow the given tight monetary policy of Japan)

Graphs are not required.

SR:

LR:

Provide sufficient argument (or steps) for your results

Answer 1

1. P_US=(Eyen/$)*P_Eyen

P_US is the dollar price of good i when sold in the U.S.

P_Eyen is the corresponding euro price in Japan

Eyen/$ is the dollar/euro exchange rate

2. Overshooting is consistent with Purchasing Power Parity (PPP). Investors forecast the expected exchange rate based on the theory of PPP. When there is some change in the market, the investors know the exchange rate will change to equate relative prices in the long run. This is why we observe overshooting in the short run—the investors incorporate this information into their short-run forecasts. Exchange rates are volatile in the short run. The theory’s implication that there is exchange rate overshooting (in response to permanent shocks) is one explanation for short-run volatility in exchange rates