Real Exchange Rate Overshooting and the Output Cost of Bringing Down Inflation

61 Pages Posted: 28 Jun 2004 Last revised: 21 Jul 2021

See all articles by Willem H. Buiter

Willem H. Buiter

Centre for Economic Policy Research (CEPR); CESifo (Center for Economic Studies and Ifo Institute); Columbia University; Independent Economic Adviser

Marcus H. Miller

University of Warwick - Department of Economics; Institute for International Economics; Centre for Economic Policy Research (CEPR)

Date Written: September 1981

Abstract

Implementing a 'gradualist' policy of monetary contraction, in an open economy with a freely floating exchange rate but with nominal inertia in domestic labor costs, can lead to prompt and substantial changes in the nominal and real exchange rate. One of the virtues claimed for such exchange rate 'overshooting', however, is its immediate effect on the price level and so on domestic wage and price inflation. In this paper we show that, in a model which is 'super-neutral' and has nominal inertia in both the level of labor costs and their trend or core rate of growth, this early overshooting of the exchange rate does not succeed in cutting the output costs of reducing steady-state inflation. Those output and unemployment costs which are initially avoided by over- valuing the currency have to be paid later when this overvaluation is corrected. Relative to other policies which achieve the same effect on steady-state inflation, exchange rate overshooting brings inflation down more quickly.

Suggested Citation

Buiter, Willem H. and Miller, Marcus H., Real Exchange Rate Overshooting and the Output Cost of Bringing Down Inflation (September 1981). NBER Working Paper No. w0749, Available at SSRN: https://ssrn.com/abstract=227533

Willem H. Buiter (Contact Author)

Centre for Economic Policy Research (CEPR)

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Marcus H. Miller

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