Abstract:
Assumption of exchange rate overshooting has significant position in international macroeconomic discussion. This phenomenon is one of the abnormal behaviors of exchange rate that happen in short run. Dornbusch (1976) shows that because speed of equilibrium prices is slow relative to asset markets and commodity prices are sticky in the short run, However, over time, commodity prices will rise and result in a decrease in real money supply and thus, in a higher interest rate. This, in turn, will cause the currency to appreciate. The aim of this article is study of exchange rate overshooting for period 2001:3-2010:2 by Vector Error Correction approach. Results show that monetary relative shock in long run and short run also effect exchange rate that imply exchange rate overshooting in Iran.
Machine summary:
"Dornbusch (1976) shows that because speed of equilibrium prices is slow relative to asset markets and commodity prices are sticky in the short run, However, over time, commodity prices will rise and result in a decrease in real money supply and thus, in a higher interest rate.
In this model for monetary shock such as increase in money supply, at the first, exchange rate moves to levels above the level of its long run and by time and prices adjustment in commodity markets, it is moving towards value of long-run equilibrium.
With regard to the importance of exchange rate and monetary policy, the objective of this paper is to study this phenomenon in Iran and relationship between exchange rate and macroeconomic variables such as money supply, national income, interest rate and inflation with the application of Vector Error Correction Model (VECM).
Monetary model with flexible prices is based on money demand function, Uncovered Interest rate Parity (UIP) and assumption of inflation expectation as follows: (1) where m is money supply, pe is expectation prices level, Y national real income and s is exchange rate.
Domestic interest rates for monetary shock and prices sticky decrease and then exchange rate relative to long run balance value comfort to overshooting phenomenon.
Conclusion This study has discussed exchange rate monetary overshooting phenomenon through using time series data, cointegration and VEC approaches to examine the relationship between exchange rate and monetary variables in Iran in the short run and long run."