Activist Monetary Policy, Imperfect Capital Mobility, and the Overshooting Hypothesis

The hypothesis of exchange rate over shooting is investigated in the context of a model that incorporates activist monetary policy, variable output, imperfect capital mobility, and slow price adjustment. Monetary policy which accommodates prices and/or interest rates is shown to increase the likelihood of undershooting. Using constrained maximum likelihood methods,the model is estimated for Germany and Japan since the advent of generalized floating in 1973. Based on the estimated parameter values, the mark exhibits overshooting while the yen is characterized by undershooting. The constraints implied by the model cannot (by likelihood ratio tests) be rejected at standard significance levels for either country.