According to Dornbusch's Overshooting Model, the short-run exchange rate volatility is mainly driven by B. Expectations of future changes in money supply.

Here's a step-by-step explanation:

1. The model begins with an increase in the money supply. This leads to a decrease in the domestic interest rate relative to the foreign interest rate.

2. The decrease in the interest rate causes capital to flow out of the country as investors seek higher returns elsewhere. This increases the supply of the domestic currency in the foreign exchange market, leading to a depreciation of the domestic currency.

3. However, because prices are sticky in the short run, the domestic currency depreciates more than it would in the long run, a phenomenon known as "overshooting."

4. Eventually, as prices adjust, the domestic currency appreciates back to its new long-run equilibrium.

So, the volatility in the short run is driven by expectations of future changes in the money supply, as these expectations influence interest rates and capital flows, which in turn affect the exchange rate.

Question

According to Dornbusch's Overshooting Model, the short-run exchange rate volatility is mainly driven by B. Expectations of future changes in money supply.

Here's a step-by-step explanation:

1. The model begins with an increase in the money supply. This leads to a decrease in the domestic interest rate relative to the foreign interest rate.

2. The decrease in the interest rate causes capital to flow out of the country as investors seek higher returns elsewhere. This increases the supply of the domestic currency in the foreign exchange market, leading to a depreciation of the domestic currency.

3. However, because prices are sticky in the short run, the domestic currency depreciates more than it would in the long run, a phenomenon known as "overshooting."

4. Eventually, as prices adjust, the domestic currency appreciates back to its new long-run equilibrium.

So, the volatility in the short run is driven by expectations of future changes in the money supply, as these expectations influence interest rates and capital flows, which in turn affect the exchange rate.

Knowee AI · Accepted Answer

According to Dornbusch's Overshooting Model, the short-run exchange rate volatility is mainly driven by B. Expectations of future changes in money supply.

Here's a step-by-step explanation:

1. The model begins with an increase in the money supply. This leads to a decrease in the domestic interest rate relative to the foreign interest rate.

2. The decrease in the interest rate causes capital to flow out of the country as investors seek higher returns elsewhere. This increases the supply of the domestic currency in the foreign exchange market, leading to a depreciation of the domestic currency.

3. However, because prices are sticky in the short run, the domestic currency depreciates more than it would in the long run, a phenomenon known as "overshooting."

4. Eventually, as prices adjust, the domestic currency appreciates back to its new long-run equilibrium.

So, the volatility in the short run is driven by expectations of future changes in the money supply, as these expectations influence interest rates and capital flows, which in turn affect the exchange rate.

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