The exchange rate is said to overshoot when its immediate response to a

disturbance is greater than its long-run response. Changes in price levels are less
volatile, suggesting that price levels change slowly.
Exchange rate overshooting is when a currency's value adjusts more than other
economic variables in response to changes in monetary policy or market
expectations. This can cause the currency's value to initially exceed its long-term
equilibrium level, but eventually return to it as other parts of the economy adjust.
Exchange rate overshooting occurs when:
Prices and wages adjust slowly
In response to a central bank's monetary policy change, the foreign exchange market
may respond immediately, but other parts of the economy, like goods and labor
markets, may not adapt as quickly.
There's an unanticipated change in the money supply
When prices are sticky, an unanticipated permanent change in the money supply can
cause the exchange rate to overshoot its long-run level.
Exchange rate overshooting can be explained using the Dornbusch overshooting
model, which assumes that output and inflation respond with a delay.
Exchange rate overshooting occurs when an exchange rate deviates from its
perceived long-run value for a sustained period of time. It can happen after an
economic shock, like an increase in the money supply.
The Dornbusch overshooting hypothesis is a well-known model in international
macroeconomics that predicts that an increase in interest rates will cause the
nominal exchange rate to appreciate immediately. The exchange rate will then
depreciate in line with uncovered interest parity (UIP).
The extent of overshooting depends on two factors:
Bond for money L: The smaller L, the steeper the mm, and the stronger the
overshooting
Market expectations: The smaller Theta, the steeper the mm, and the stronger the
overshooting
However, empirical evidence for the overshooting prediction is mixed. Early studies
using vector autoregressive models (VARs) indicate that the exchange rate response
to a monetary shock is not immediate.
Exchange rate overshooting occurs when the exchange rate moves beyond its long-
term equilibrium value before returning to it. This can happen when the exchange
rate changes quickly, but other parts of the economy, like wages and prices, don't
adjust as fast. Some causes of exchange rate overshooting include:
Monetary policy changes
When a central bank changes monetary policy, like interest rates or the money
supply, the foreign exchange market can respond immediately.
Price stickiness
When prices and wages are sluggish to adjust, the exchange rate may overshoot its
long-term equilibrium value. This can be due to contracts, menu costs, or other
factors.
Rigidities in price and wage setting mechanisms
When price and wage setting mechanisms are rigid, the exchange rate may
overshoot.
Fiscal policy
When fiscal policy puts upward pressure on the exchange rate, the exchange rate
may overshoot.
Some say that the best way to address exchange rate overshooting is to attack the
underlying causes, rather than trying to regulate exchange rate movements.
Exchange rate overshooting can have several consequences, including:
Output loss: Output loss increases with overshooting debt.
Debt intolerance: Output loss also increases with the level of development, which is
a consequence of debt intolerance.
Exchange rate overshooting occurs when the exchange rate immediately overshoots
its long-run level after an unanticipated permanent change in the money supply. This
can happen because prices don't react instantly to changes in the money supply.
2,Final answer: The short-run effect on the exchange rate of an increase in domestic
real GNP, given expectations about future exchange rates, is that it can lead to an
increase in demand for the domestic currency.Aug 8, 20
The short-run effect on the exchange rate of an increase in domestic real GNP, given
expectations about future exchange rates, is that it can lead to an increase in
demand for the domestic currency. However, the effect on the exchange rate also
depends on whether expectations about future exchange rates are favorable or
unfavorable.
Explanation:
In the short run, an increase in domestic real GNP can have an effect on
the exchange rate. When the domestic real GNP increases, it indicates that the
economy is growing and becoming more productive. This can lead to an increase in
demand for the domestic currency as investors and traders anticipate higher returns.
However, the effect on the exchange rate also depends on expectations about future
exchange rates. If expectations about future exchange rates are favorable, it can
further strengthen the domestic currency. This is because investors and traders
would prefer to hold the domestic currency if they expect it to appreciate in value.
On the other hand, if expectations are unfavorable, it can weaken the domestic
currency. In this case, investors and traders may prefer to hold other currencies that
are expected to appreciate.
The short-run effect on the exchange rate of an increase in domestic real GNP, given
expectations about the future exchange rate, is likely to be an appreciation of
the domestic currency.
When domestic real GNP increases, it indicates a growing and strong economy,
which can attract foreign investment and create higher demand for the domestic
currency. This increased demand for the currency tends to drive up its value relative
to other currencies in the short run . Additionally, if there are positive
expectations about the future exchange rate, such as anticipated policy changes or
economic conditions, it can further strengthen the domestic currency. Investors may
buy the currency in anticipation of future gains, leading to an increase in its value
3,A reduction in aggregate real money demand, or a negative shift in the aggregate
real money demand function, has the following short-run and long-run effects on the
exchange rate, interest rate, and price level:
Short-run: The interest rate decreases, and the exchange rate increases. This is
because the real money supply does not change, so the equilibrium interest rate
declines. The interest parity condition then implies that the exchange rate increases.
Long-run: The price level adjusts to keep the interest rate unchanged.
A permanent change in real money demand does not affect the long-run real
exchange rate or the nominal interest rate.
Aggregate Demand:
Aggregate Demand is an economic term that can be defined as total money that has
been spent on goods and services in an economy during a specific period of time. In
other words, it is the demand for a country's GDP.
Answer and Explanation: 1
A reduction in the aggregate real money demand will move the L(R,Y) curve to the
left. However, in the short-run, the Ms/P curve does not change because the price
and money supply are fixed. Therefore, the new equilibrium is in R1 where the
interest rate is lower. Finally, based on the interest rate parity theory, we can see
that the exchange rate increases to E1. In the long-run, the price must be adapted to
maintain unaltered the interest rate. Thus, the price levels increase equating the
money demand and supply at the beginning. This change will lead to R0 equating the
original exchange rate E0.
4,According to relative purchasing power parity (PPP), the Swiss franc should
appreciate against the Russian ruble over the year. This is because Russia's high
inflation rate erodes the value of the ruble, reducing its demand.
The Swiss franc should appreciate by 95 percent against the Russian ruble over the
year according to relative PPP given an inflation rate of 100 percent in Russia and 5
percent in Switzerland.
hapter 16: Problem 1
Suppose Russia's inflation rate is 100 percent over one year but the inflation rate in
Switzerland is only 5 percent. According to relative PPP, what should happen over
the year to the Swiss franc's exchange rate against the Russian ruble?
Short Answer
Expert verified
The Swiss franc should appreciate by approximately 90.48% against the Russian
ruble over the year, according to relative PPP.
Step by step solution
01
Understanding Relative Purchasing Power Parity (PPP)
Relative Purchasing Power Parity (PPP) suggests that exchange rates between
currencies should adjust to compensate for inflation rate differences between two
countries. If Russia's inflation rate is higher, the value of its currency should decrease
relative to the currency of Switzerland.
02
Identify the Inflation Rates
Firstly, ascertain the inflation rates of the countries involved. For Russia, the inflation
rate is 100%, and for Switzerland, the inflation rate is 5%.
03
Calculate the Expected Change in Exchange Rate
According to the principle of relative PPP, the adjustment in the exchange rate
should be proportional to the inflation rate difference. The formula is: Exchange Rate
Change = (1 + Inflation Country A) / (1 + Inflation Country B) - 1. Where Country A
has the higher inflation rate.
04
Apply the Inflation Rates to the PPP Formula
Substitute the inflation rates of Russia (100% or 1 in decimal) and Switzerland (5% or
0.05 in decimal) into the PPP formula: Expected Change = (1 + 1) / (1 + 0.05) - 1.
05
Calculate the Numerical Change
Perform the calculation: (2 / 1.05) - 1 = 0.9048 or 90.48%.
06
Interpret the Result
A result of 90.48% suggests that, according to relative PPP, the Swiss franc should
appreciate by approximately 90.48% against the Russian ruble over one year due to
the inflation rate differential.
Key Concepts
These are the key concepts you need to understand to accurately answer the
question.
Exchange Rate Adjustment
Exchange rate adjustment is a crucial concept in understanding how currencies
interact with one another on the global market. It refers to the changes in the value
of one currency relative to another. These adjustments occur for several reasons,
but primarily due to differences in economic indicators, such as inflation rates,
interest rates, and economic growth between two countries.

For instance, when a country experiences higher inflation than another, its currency
tends to weaken because the purchasing power of its currency is eroding faster. This
necessitates an adjustment in the exchange rate to reflect the new value of the
currency. According to relative Purchasing Power Parity (PPP), the exchange rate
should adjust so that it can buy the same amount of goods and services in both
countries.

This concept helps traders and economists predict how currencies will move against
each other, providing a method to compare economic strength and make investment
decisions. For students and observers, understanding this adjustment process is vital
for grasping the dynamics of international economics.
Inflation Rate Difference
Inflation rate difference is the variation in the rate at which the general level of
prices for goods and services is rising in different countries, and subsequently,
purchasing power is falling. Economies typically aim for a certain level of inflation
that is considered healthy, as it indicates growth. However, significant differences in
inflation rates between countries can affect trade and exchange rates.

As seen in our example with Russia and Switzerland, a high inflation rate in Russia
compared to a low rate in Switzerland indicates that the cost of living is increasing
much faster in Russia. This difference impacts how much consumers in each country
can buy with a set amount of money. For students, it's important to understand that
these differences can lead to adjustments in exchange rates, as currencies will
fluctuate to maintain relative purchasing power across borders.
Relative PPP is directly impacted by these inflation disparities, suggesting that a
currency from a high-inflation country will depreciate against a currency from a low-
inflation country. Understanding this concept can aid in predictive analysis of
currency movements.
Currency Value Appreciation
Currency value appreciation refers to the increase in value of one currency relative
to another. When a currency appreciates, it can buy more of a foreign currency than
before. This appreciation impacts international trade, as goods priced in the
appreciating currency become more expensive for foreign buyers, while imports
become cheaper for consumers paying with the appreciating currency.

In the context of our exercise, due to the inflation rate difference, we expect the
Swiss franc to appreciate against the Russian ruble. Appreciation can occur due to
various factors such as higher interest rates attracting foreign capital, economic
growth, or lower inflation rates, as demonstrated in the relative PPP prediction. For
students, recognizing the signs and effects of currency appreciation is essential in
understanding international finance and making informed decisions in global
markets.

Additionally, students should be aware that while currency appreciation might

benefit consumers by making imports cheaper, it can also have negative effects on
exporting industries by making their products less competitive abroad.
PPP Calculation Formula
The PPP calculation formula is a mathematical representation of the relative
Purchasing Power Parity theory. It allows us to estimate how much the exchange
rate should adjust to account for differences in inflation rates between two
countries. According to relative PPP, the formula is expressed as:
Exchange Rate Change=(1+Inflation Country A1+Inflation Country B)−1
where 'Country A' has the higher inflation rate.

In our example, by substituting the inflation rates for Russia (100% or 1 in decimal
form) and Switzerland (5% or 0.05 in decimal form), we calculate the expected
change in exchange rate. Following the PPP calculation formula, students can
understand how theoretical exchange rate levels can be derived based on the
economic conditions of involved countries.

It is important for students to practice applying this formula to different scenarios to

strengthen their grasp on how exchange rates could potentially adjust in response to
varying inflation rates, thereby improving their comprehension of international
economic principles.
Short Answer. Exporters suffer when their home currency appreciates because their
goods become more expensive and less competitive abroad. They benefit when their
home currency depreciates as it makes their exports cheaper and more attractive to
foreign buyers.
Exporters suffer when their home currency appreciates because their goods become
more expensive and less competitive abroad. They benefit when their home
currency depreciates as it makes their exports cheaper and more attractive to
foreign buyers.
Step by step solution
01
- Understanding Currency Appreciation
Currency appreciation means that the value of a country's currency has increased
relative to another country's currency. As a result of the stronger currency, the
prices of that country's goods and services become more expensive for foreign
buyers since they'll need more of their own currency to make a purchase. This can
lead to a decrease in export sales because foreign buyers may seek cheaper
alternatives.
02
- Understanding Currency Depreciation
Conversely, when a country's currency depreciates, or loses value compared to other
currencies, its goods and services become cheaper for foreigners. This can lead to an
increase in demand for the country's exports as foreign buyers take advantage of the
lower prices.
03
- Effects on Exporters
Exporters suffer when their home currencies appreciate because their goods become
less competitive in terms of price, dampening foreign demand. When the home
currency depreciates, exporters generally benefit as their goods are cheaper on the
global market, potentially leading to an increase in sales.
Key Concepts
These are the key concepts you need to understand to accurately answer the
question.
Real Currency Appreciation
Understanding the concept of real currency appreciation is essential in international
economics. Simply put, when a country's currency strengthens in value against
another's, we call it real currency appreciation. This strength is not just in exchange
rates but also when accounting for inflation differences between countries. For
instance, if the US dollar gains value against the euro and this change is greater than
the inflation rate in the US compared to the EU, the real value of the dollar has
appreciated.

What does this mean for exporters? Their goods become relatively more expensive
for buyers using other currencies. Imagine an American wine producer finds that
after real currency appreciation, Europeans may have to spend more euros to buy
the same bottle of wine. Unless the wine has a unique quality that justifies the
higher price, the producer might see a decrease in sales in Europe. Real currency
appreciation makes a country's exports less attractive on the world market because
foreign consumers and businesses can find cheaper alternatives elsewhere, shifting
their demand away from products from the country with the appreciated currency.
Export Sales
The term export sales refers to the revenue generated by a country's companies
from selling goods or services abroad. Export sales are a vital component of a
nation's economy as they can contribute to job creation and economic growth. High
export sales mean that a country’s products are in demand globally, reinforcing the
strength of its industries.

However, export sales are sensitive to currency fluctuations. When the domestic
currency appreciates, as mentioned earlier, exports can become more expensive for
foreign buyers, negatively impacting export sales. Conversely, a weaker domestic
currency often translates to more competitive export pricing, boosting sales. This
push-and-pull dynamic is a crucial aspect of trade economics, highlighting the
reliance of export sales on currency valuation and highlighting why businesses and
policymakers closely monitor exchange rate movements.
Currency Depreciation
Currency depreciation is when a currency falls in value relative to other currencies.
This is the flip side of currency appreciation and has its own set of effects on the
economy. When a currency depreciates, it's often considered bad news for
consumers, as imported goods become more expensive, leading to higher costs for
items and possibly inflation.
For exporters, however, a silver lining exists. A depreciated currency means that
foreign buyers will find the country's goods and services cheaper, which can give a
boost to exports. A weaker currency can make a country's exports more competitive
internationally because they are a better deal for buyers with stronger currencies.
For instance, let's say the Japanese yen depreciates against the British pound. As a
result, British consumers might be more inclined to purchase Japanese electronics,
which now cost them less than before the yen's depreciation.
Global Market Competitiveness
Global market competitiveness is how effectively a country or company can compete
on the international stage, offering products or services that meet the standards of
quality, price, and demand compared to others. It is influenced by a variety of
factors, including innovation, technology, productivity, cost, infrastructure, and
currency value.

When a currency appreciates or depreciates, it can alter a nation’s global

competitiveness. A stronger currency may make a country's exports less competitive
due to higher costs. On the other hand, a weaker currency might improve
competitiveness by making exports cheaper and more appealing to international
buyers. To maintain competitiveness, countries strive to balance currency values
with other factors, such as improving technology or reducing production costs,
ensuring that their products remain attractive to buyers regardless of currency
fluctuations.
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