Intervention needed to mitigate costs of exchange-...

Intervention needed to mitigate costs of exchange-rate overshooting

The Dornbusch (1976)overshooting model showed that a move to monetary restraint can lead to a short-run real exchange-rate appreciation, while an expansionary monetary policy can lead to a real depreciation.These real-exchange rate movements (over and under valuations in relation to PPP)will exert effects on the real economy.In what follows we shall refer to substantial and prolonged deviations from PPP as exchange-rate misalignments.

Misaligned exchange rates distort the allocation of resources between the tradables and the non-tradables as well as consumption patterns between the two.Undervaluation by raising the domestic price level and placing downward pressure on real wages may spark off inflationary pressures, while overvaluation by squeezing the tradable sector may result in increased unemployment.Misalignment complicates and inhibits investment decisions because uncertainty as to the duration of the over/undervaluation will affect the profitability calculations concerning whether to invest in the tradable or non-tradable, particularly inhibiting marginal investment decisions.

Misalignments almost certainly exert a ratchet effect on protectionism.In periods of undervaluation of the currency, resources that would ordinarily not be viable enter into the tradable sector but as the rate corrects itself they will come under increasing pressure and will then seek recourse to protection.Alternatively, if the currency is overvalued this will tend to lead to automatic protectionist cries due to the pressure on the tradable sector.It should also be remembered that undervaluation for one currency involves overvaluation for another and vice versa, so that one could expect protectionism to be a global and persistent phenomenon so long as exchange rates are misaligned.Since an under/overvaluation must necessarily eventually be corrected, this will involve the various adjustment costs arising because of factor immobility occupationally and geographically; retraining of labor will involve cost and time and absorption cannot be painlessly varied at will.

Foreign exchange intervention designed to reduce the costs and extent of exchange-rate overshooting could be justified.It is worth noting that the case for intervention in this instance is not in any way due to inefficiency in the foreign exchange market.The rate produced by the market is the correct rate but because of “sticky” goods prices there are short-run real exchange-rate changes.If the price level increased (decreased)by × percent immediately following an × percent change in the money supply, as in the flexible-price monetary model, then there would be no overshooting of the exchange rate.This latter observation has led some authors to propose that, rather than intervene in the foreign exchange market; the authorities should tackle the inefficiencies in the goods and labor markets.If these markets were made more flexible so that the rate of inflation adjusted quickly to changes in monetary policy, then this would reduce the amount of overshooting.The measures proposed would include anti-trust legislation, reductions in trade union power, and the reduction of social security benefits, all of which would make goods and factors prices more flexible and thereby reduce the problem of overshooting.Not surprisingly, in comparison to the likely resistance and turmoil associated with such policies, exchange market intervention can prove a superior policy tool.