Question

Assume also that goods prices are sticky in the short run. Suppose the US central bank implements a contractionary monetary policy in a permanent fashion, and market participants correctly anticipate this policy two months in advance. Use the MM-FX model to explain changes in the dollareuro exchange rate in the short run and the long run. Is there exchange rate overshooting?

Answer 1

Answer:

Domestic and foreign rates of return converge, as depreciation of the euro raises returns for U.S. investors who purchase euro-based assets.

Explanation:

When there is an  increase in the quantity of money, it is made  to be permanent and prices are adhesive, then in the short term the rate of exchange diminishes  because the fall of the domestic nominal returns is relative to foreign returns, and traders expect a fall in future for exchange rates.