Overshooting and Exchange Rate Disconnect Puzzle: A Reappraisal

Jean-Olivier Hairault (), Lise Patureau () and Thepthida Sopraseuth ()

Macroeconomics from EconWPA

Abstract: Transitions to floating exchange rate regimes have led to sharp increases in exchange rate volatilities with no corresponding changes in the distribution of macroeconomic fundamentals. In the spirit of Dornbusch (1976), we assess whether nominal exchange rate overshooting is responsible for this phenomenon. As long as uncovered interest rate parity holds, nominal exchange rate overshooting is linked to a persistent fall in the spread between domestic and foreign nominal interest rates. We thus develop a limited participation model in a small open economy setting. With small adjustment costs on money holdings, overshooting substantially contributes to the nominal exchange rate volatility.

Keywords: Exchange rate disconnect puzzle; liquidity effect; overshooting; uncovered interest rate parity (search for similar items in EconPapers)
JEL-codes: F31 F41 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-dge and nep-ifn
Date: 2004-10-01
Note: Type of Document - pdf; pages: 33

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Persistent link: http://EconPapers.repec.org/RePEc:wpa:wuwpma:0410001

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