EXCESS VARIABILITY AND STABILITY IN THE DYNAMIC ADJUSTMENT OF EXCHANGE RATE UNDER ACTIVIST MONETARY POLICIES: A THEORETICAL AND EMPIRICAL STUDY

This study investigates the issue of excess variability of short-run exchange rate following a monetary shock. The issue has been studied in two different sequences. First, time path of exchange rate and relative price level have been derived in the set up of a model where capital is perfectly mobile, prices make lagged adjustment, expectations are of perfect foresight variety, output levels are variable and monetary policies are 'activist' in the sense that money supplies in countries concerned are related to variations in exchange rate and relative price level. The stability of the dynamic paths of exchange rate and relative price level has been examined and conditions for stability have been specified. Moreover, conditions for 'overshooting' and 'undershooting' have also been derived. The Deutsche Mark/Dollar exchange rate variations over the period 1973(I)-1985(I) have been subject to empirical investigations. Mark/Dollar exchange rate is found to 'undershoot' over the period of study. 'Overshooting' is not, therefore, the intrinsic phenomenon of foreign exchange market.;Second, the nature of short-run exchange rate variability with the assumption that Purchasing Power Parity holds in the long run has also been studied. An exchange rate equation has been derived through the integration of current and capital accounts. In this model current prices are not rigid but allowed to have limited flexibility. Exchange rate is again found to 'undershoot' when output levels are variable and monetary policies are 'activist'. Moreover, activist monetary policies with exogenous output levels are found to explain such 'undershooting' of exchange rate. Thus flexibility of price level improves upon the importance of activist monetary policies in ensuring 'undershooting'. Output variability, on the other hand, emerges as the necessary, though not sufficient, condition for 'undershooting' of Mark/Dollar exchange rate.;The relative importance of 'activist' monetary policies and 'output variability' in the observed 'undershooting' of exchange rate has been examined. 'Output variability' is found to be the prime factor behind observed 'undershooting' of exchange rate. Activist monetary policies, in the absence of output variability, fail to explain the observed 'undershooting' of Mark/Dollar exchange rate.