Abstract
Exchange-rate volatility may be attributable to shifting market expectations, even in the absence of exogenous or policy induced shocks. The response of optimizing monetary policy to transitory deviations from rational expectations is examined. The effects of such deviations are shown to be enduring, their magnitude depending inter alia on the relative weight given by the authorities to output growth and price stability, and to differ qualitatively from overshooting of the Dornbusch type.
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