Real Exchange Rate Overshooting and the Output Cost of Bringing Down Inflation

   (458 K)

Implementing a 'gradualist' policy of monetary contraction, in an open economy with a freely floating exchange rate but with nominal inertia in domestic labor costs, can lead to prompt and substantial changes in the nominal and real exchange rate. One of the virtues claimed for such exchange rate 'overshooting', however, is its immediate effect on the price level and so on domestic wage and price inflation. In this paper we show that, in a model which is 'super-neutral' and has nominal inertia in both the level of labor costs and their trend or core rate of growth, this early overshooting of the exchange rate does not succeed in cutting the output costs of reducing steady-state inflation. Those output and unemployment costs which are initially avoided by over- valuing the currency have to be paid later when this overvaluation is corrected. Relative to other policies which achieve the same effect on steady-state inflation, exchange rate overshooting brings inflation down more quickly.

Published:

• Buiter, Willem H. and Miller, Marcus. "Real Exchange Rate Overshooting and the Output Cost of Bringing Down Inflation." European Economic Review, Vol. 18, No.1, 1982, pp.85-123. ,
• Buiter, Willem H. and Miller, Marcus. "Real Exchange Rate Overshooting and the Output Cost of Bringing Down Inflation: Some Further Results." Exchange Rates and International Macroeconomics, edited by Jacob A. Frenkel. Chicago: UCP, (1983), pp. 317-368. ,
• Buiter, Willem H. and Miller, Marcus. "Real Exchange Rate Overshooting and the Output Cost of Bringing Down Inflation." International Volatility and Economic Growth: The First Ten Years of The International Seminar on Macroeconomics, edited by Georges de Ménil and Robert J. Gordon, p. 239 - 277. ,
• Real Exchange Rate Overshooting and the Output Cost of Bringing Down Inflation: Some Further Results, Willem H. Buiter, Marcus Miller, in Exchange Rates and International Macroeconomics (1983), University of Chicago Press
  This paper was subsequently published as Real Exchange Rate Overshooting and the Output Cost of Bringing Down Inflation, Willem H. Buiter, Marcus Miller, in International Volatility and Economic Growth: The First Ten Years of The International Seminar on Macroeconomics, Elsevier Science Publishers B.V., 1991
  

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