Question #41
Reading: Reading 5 Currency Exchange Rates - Understanding Equilibrium Value
PDF File: Reading 5 Currency Exchange Rates - Understanding Equilibrium Value.pdf
Page: 16
Status: Unattempted
Question
Ashok Jain is assessing the currency value of Lutina. Jain believes that prices are sticky in the short term and, hence, do not immediately reflect changes in monetary policy. If Lutina announces a change to a restrictive monetary policy, Jain would most likely conclude that Lutina's currency would:
Answer Choices:
A. excessively depreciate in the long-term
B. excessively appreciate in the long-term
C. excessively appreciate in the short-term
Explanation
Dornbusch overshooting model. This model assumes that prices are sticky (inflexible) in
the short term and, hence, do not immediately reflect changes in monetary policy.
The model concludes that exchange rates will overshoot the long-run PPP value in the
short term. A restrictive monetary policy leads to excessive appreciation of the domestic
currency in the short term and then a slow depreciation toward the long-term PPP value.