Monetary changes and overshooting of agricultural prices in the short run in an open economy

This dissertation formalizes the 'overshooting' of agricultural prices by applying an extension of Frankel's (1986) model to an open economy. The main focus of the analysis presented in this paper is on the adjustment path of the exchange rate and prices in response to an unanticipated system shock; namely, an increase in the money supply.;The study formalizes the argument that the money neutrality proposition holds only in the long run, and in the short run a shock in nominal money is a shock in real money, which leads to changes in relative prices between the 'fix-' and 'flex-' price sectors.;The overshooting hypothesis, originally developed by Dornbusch (1976b) to describe foreign exchange markets, asserts that monetary changes can have real effects on relative prices in the short run. The overshooting hypothesis is based on the theory that whenever some markets adjust slowly in response to a monetary change, sectors of the economy that are free to move must bear the burden of the sticky sectors. In this research the prices of agricultural commodities and financial assets are assumed to be flexible and adjust quickly to monetary shocks, but the prices of other goods are assumed to be sticky.;The results of this research indicate that with the existence of a sticky sector, in case of a monetary shock, the burden of adjustment, in the short run, is shared by the two flexible sectors. The prices of the flexible sectors both overshoot their long-run equilibrium levels whenever there is an unanticipated monetary change, but the degree of overshooting in the two flexible sectors is different. These results indicate that having a flexible exchange rate dampens the overshooting of agricultural prices and vice-versa.;Because of the dynamic nature of this type of economic model, a brief discussion of the stability of dynamic models is included and the divergence or convergence of the adjustment paths is analyzed. This analysis reveals that the dynamic models of price and exchange rate determination which assume perfect foresight are unstable, and the instability is a 'saddle-point' type instability.