Abstract
Exchange rate behaviour does not follow very obvious and predicted pattern. Many attempts have been made to predict its behaviour as much as possible. This research re-examines the Dornbusch’s model of exchange rate overshooting caused by price rigidities. Dornbusch’s assumption of full employment in economy has been violated in this research which creates the possibility of exchange rate undershooting. In response to positive monetary shock, interest rate decreases and exchange rate undershoots its long run equilibrium. This research explains the dynamics of anti-intuitive exchange rate undershooting. Apart from theoretical formations of exchange rate undershooting, this research also analyses Pakistani data for exchange rate undershooting or overshooting in response to increase in money supply. Quarterly data of twenty three years for exchange rate, nominal interest rate, price, real output and money have been taken and vector autoregressive technique has been used. Evidence of exchange rate undershooting in response to positive money supply shock was found. It also gives an important insight into policy making by identifying some probable behaviour of exchange rate.
Highlights
Countries sometimes face many issues in implementation of monetary and fiscal policies whereas theoretical and policy recommend-Author’s Note: We would like to express our deep and sincere gratitude to School of Social Sciences and Humanities, National University of Sciences and Technology (NUST), Pakistan for completion of this research
We introduce production lag explaining that output is sluggish and takes some time to adjust. ẏ, i.e., is rate at which output expands and it depends on real exchange rate and interest rate. μ could be any external factor such as fiscal policy, exogenous shocks, etc. α is the speed of adjustment of output
By using vector autoregression (VAR), we tried to analyze the effects of unit shock in money supply on nominal exchange rate, prices, real output and nominal interest rate
Summary
Countries sometimes face many issues in implementation of monetary and fiscal policies whereas theoretical and policy recommend-Author’s Note: We would like to express our deep and sincere gratitude to School of Social Sciences and Humanities, NUST, Pakistan for completion of this research. We would like to especially thank Dr Ather Maqsood Ahmed for personal guidance, which has provided a good basis and shape for current research. We would like to thank Dr Zafar Mahmood and Dr Tanwer ul Islam for their critique and guidance that has improved the quality of the paper. Actual evidence sometimes differs from the theory suggested by monetarists and fiscal policy makers. Opening of world trade and global economies have made one country vulnerable to policies of other countries. Mundell’s (1963) and Fleming (1962) models explained the conductance of monetary and fiscal policy in different exchange rate regimes. Mundell’s model is still the basis of many ideas and theories of international finance but it was really back dated
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