When an increase in the quantity of money is considered to be permanent and prices are sticky, then in the short run the exchange rate depreciates and overshoots because:
A) domestic nominal returns fall relative to foreign returns, and traders expect a permanent depreciation in future exchange rates.
B) traders do not change their expectations of the exchange rate, and lower domestic rates make it easier to borrow.
C) inflationary expectations eventually cause a rise in domestic real returns.
D) traders quickly realize that their expectations of future exchange rates are incorrect and eventually prices will become unstuck.

Question

Quizplus · Accepted Answer

When there is an increase in the quantity of money considered as permanent and prices are sticky, the domestic nominal returns fall relative to foreign returns. This results in traders expecting permanent depreciation in future exchange rates leading to a depreciation of the exchange rate in the short run. The depreciation of the exchange rate overshoots because traders initially have incorrect expectations of future exchange rates, and it takes time for these expectations to adjust to the new information resulting from the increase in the quantity of money. Thus, option A is the best choice.

When an Increase in the Quantity of Money Is Considered