Does the exchange rate overshoot in an emerging economy?

Muhammad Aftab, Amir Rafique and Evan Lau

Journal of Chinese Economic and Foreign Trade Studies, 2021, vol. 15, issue 1, 1-15

Abstract: Purpose - The sticky-price monetary model of exchange rate states the overshooting hypothesis as, exchange rate depreciation beyond its long-term value in response to an increase in money supply owing to the sticky nature of prices. Because of interest and relevance to policy, there is a huge extant literature on it but with mixed findings that suggest the need for further studies to refine the findings. Pakistan’s rupee exchange rate against the US dollar depreciated 128.44% over the period May 2007–December 2018. Considering this substantial decline in rupee's value, this study aims to examine either the rupee short-run value is over-shot of its long-term value. Design/methodology/approach - This study uses a linear ARDL approach that segregates the short-run and long-run effects thus clarifying the premise of exchange rate overshooting. Furthermore, this study also uses nonlinear ARDL as a robustness check incorporating structural breaks. Findings - Findings based on a linear model show evidence of exchange rate undershooting that means a positive money shock causes the exchange rate to appreciate. A nonlinear analysis also provides support to these findings. However, the increase in relative money supply has more such effect than that of a decrease in the relative money supply. Moreover, the authorities’ inclination to stabilize the exchange rate appreciates its short-run value. Originality/value - This study substantiates the overshooting hypothesis literature by considering the role of asymmetric effects of exchange rate determinants and structural breaks that is a rare attempt in the extant literature.

Keywords: Pakistan; Emerging economy; Exchange rate overshooting; Nonlinear ARDL; Sticky-price monetary model (search for similar items in EconPapers)
Date: 2021
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Persistent link: https://EconPapers.repec.org/RePEc:eme:jcefts:jcefts-12-2020-0075

DOI: 10.1108/JCEFTS-12-2020-0075

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