Questions: Exchange Rate Dynamics and Purchasing Power Parity

Question 1

The Federal Reserve unexpectedly raises U.S. interest rates. According to the Dornbusch overshooting model, what happens to the dollar in the short run versus the long run?

• A. The dollar depreciates immediately as investors sell U.S. assets anticipating future inflation, then appreciates gradually
• B. The dollar appreciates gradually over several years as capital flows in from abroad seeking higher returns
• C. The dollar appreciates immediately beyond its new long-run equilibrium, then depreciates gradually back toward it
• D. The dollar remains stable in the short run because goods prices offset the interest rate effect quickly

Answer: (C)

This is the Dornbusch overshooting mechanism. Asset prices (exchange rates) adjust instantly; goods prices are sticky. Higher U.S. rates attract capital immediately, causing a large, sudden appreciation — beyond the new PPP-justified long-run level. Then, as uncovered interest parity must hold over time, the dollar gradually depreciates back. The overshoot is necessary: if the dollar jumped only to its long-run level, there would be no expected future depreciation to equalize returns, violating UIP.

Question 2

Relative PPP predicts that if U.S. inflation exceeds European inflation by 2%, the dollar should depreciate 2% annually. This prediction works reasonably over decades but fails over months. Why?

• A. PPP only applies to non-traded goods, which are excluded from standard inflation measures
• B. In the short run, currencies are traded as financial assets responding to interest rate differentials, risk sentiment, and capital flows — not primarily to price level differences
• C. Central banks systematically intervene to prevent the exchange rate changes that PPP predicts
• D. Inflation data is published with a multi-year lag, preventing markets from responding to it

Answer: (B)

Currencies are financial assets whose prices reflect expected future returns, not just the current price level. In the short run, a 25-basis-point surprise interest rate change moves exchange rates more than years of accumulated inflation differential. Capital flows respond to return differentials instantaneously; goods arbitrage operates over months or years. PPP reasserts itself over long horizons as goods markets gradually adjust, but it is dominated by financial market forces in the short run.

Question 3

Relative purchasing power parity holds much better as a prediction over horizons of several decades than over short horizons of months or quarters.

• T. True
• F. False

Answer: True

Empirically, this is well-established. Over horizons of 20–30 years, real exchange rates do tend to revert toward PPP-implied levels, and inflation differentials explain a large portion of nominal exchange rate movements. Over months or quarters, however, real exchange rates can diverge dramatically from PPP, driven by capital flows, interest rate differentials, and sentiment. The short-run disconnect is precisely what Dornbusch's overshooting model explains.

Question 4

When a country's interest rates rise, investors buy its currency to earn higher returns, and the currency will continue appreciating for as long as the interest rate differential persists.

• T. True
• F. False

Answer: False

Uncovered interest parity (UIP) predicts the opposite trajectory after the initial jump. The currency appreciates immediately (often overshooting), but must then be expected to depreciate over time to equalize returns. If domestic rates are 2% above foreign rates, the currency must be expected to depreciate by roughly 2% per year for returns to equalize. An investor who bought the currency at the peak gets the interest rate gain but loses on the subsequent depreciation — in theory, the two exactly offset. Continued appreciation would create a free-money arbitrage that markets would eliminate.

Question 5

Explain exchange rate overshooting: why does a monetary contraction cause a currency to appreciate beyond its new long-run equilibrium, and what drives it back?

Model answer: Monetary contraction raises interest rates. Asset prices (exchange rates) adjust instantly — capital flows in, appreciating the currency immediately. But goods prices are sticky and adjust slowly, so the real exchange rate overshoots its new equilibrium. Uncovered interest parity requires that the now-overvalued currency be expected to depreciate going forward, which provides the return equalization. As goods prices eventually adjust and inflation falls in line with the lower money growth, the exchange rate gradually depreciates back toward the new long-run PPP-consistent level.

The key to overshooting is the asymmetry between asset market adjustment (instantaneous) and goods market adjustment (gradual). The exchange rate must do extra work in the short run to compensate for prices that cannot yet move. This explains why exchange rate volatility far exceeds what inflation differentials alone would predict: currencies absorb all the adjustment that sticky prices cannot, and then partially reverse as those prices catch up. Dornbusch (1976) formalized this insight and it remains one of the most influential results in open-economy macroeconomics.