Question

a. What is the exchange rate overshooting model?

b. If the Fed announces that they will lower the interest rate by 0.5% next Wednesday, plot the time paths showing its effects on: (a). The dollar interest rate. (b). The U.S. price level. (c). The dollar/euro exchange rate.

Answer 1

a : Exchange Rate Overshooting Model

ANSWER : Exchange Rate Overshooting Model was proposed by Rudi Dornbusch. The model tries to explain the high volatility in exchange rates. The main assumption of the model is that the price of goods are sticky. With this the model says that when there is a change in monetary policies, the foreign exchange rates will react to this change temporarily in order to compensate the sticky price. It explains the volatility of exchange rates in a situation when economy moves from fixed exchange rates to flexible exchange rates. Thus in overshooting model, it put forward a relationship between sticky price and exchange rate volatility. When there is a change in exchange rates in an economy, price will not change immediately since prices are assumed to be sticky. But the effect of change in exchange rates will have effect on other factors. And this will move like a domino effect and finally effect price.