Monetary and Fiscal Policy Under Nonlinear Exchange Rate Dynamics

Abstract

A nonlinear exchange rate model based on the famous Dornbusch (1976) overshhoting model is modified to allow for explicit consideration of the sources of supply and demand in the foreign exchange market along the lines suggested by Kouri (1983). Imperfect substitutability between domestic and foreign assets and finite speed of adjustment are intorduced into the foreign exchnage market. Portfolio considerations dictate that the function describing the fraction of wealth domestic residents desire to hold in foreign assets be nonlinear. The exchange rate dynamics are governed by a set of nonlinear differential equations which exhibit limit cycle behaviour under perfect foresight. A number of fiscal and monetary policies are examined within the framework of the nonlinear model and compared with results with results obtained in the traditional linear mode of analysis.