Wednesday, 9 November 2011

Exchange Rate Overshooting in my own words..

The Overshooting condition states that permanent money supply increases lead to exchange rate depreciation in short run being larger than exchange rate depreciation in long run.
As money supply increases lead to returns on domestic currency deposits going down, but in long-run all returns equalize for this to happen exchange rate must appreciate. But this will only happen if exchange rate has depreciated beyond long run level and this will happen because in short run price is rigid, given this, increase in money supply causes short term interest rates to go down which means domestic returns fall below foreign returns, this permanent increase in money supply also means that the price of the domestic currency rises in terms of foreign currency, so expected exchange rate of domestic currency rises and exchange rate depreciates thus looked at simply(without expectations) because domestic returns fall there is a disincetivisation of foreign capital to invest in domestic economy. Thus foreign capital outflow increases and domestic currency depreciates. But in the long run "price rises" forcing central banks to increase rates in  response to rising inflation. This increase in rates attracts foreign capital leading to little appreciation of domestic currency. Thus, the domestic currency comes back to its long run depreciated equilibrium level. If the increase in money supply were temporary there would be no change in real money supply and simply the exchange rate would go directly to its long run level, remember the overshooting is there because in case of permanent money supply change there is a decline in domestic interst rate followed by depreciation of exchange rate, and a little bit of appreciation only in the long run whereas if money supply change is temporary there is only direct depreciation of exchange rate.

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