In the United States, where there is a permanent increase in the money supply, exchange rate overshooting is caused in part by:
A) higher domestic interest rates.
B) an appreciation of the dollar.
C) lower foreign interest rates.
D) a depreciation of the dollar.

Question

Quizplus · Accepted Answer

According to the theory of exchange rate overshooting, a permanent increase in the money supply causes a short-term depreciation of the domestic currency (in this case, the dollar) due to the increase in the supply of the currency on the foreign exchange market. This short-term depreciation is greater than the long-term depreciation that would occur in response to the increase in the money supply, leading to exchange rate overshooting. Therefore, the correct answer is a depreciation of the dollar (choice D). Higher domestic interest rates (choice A) would lead to capital inflows and appreciation of the dollar, which is opposite to the direction of overshooting. Lower foreign interest rates (choice C) would also lead to capital inflows and appreciation of the dollar, which is again opposite to overshooting. An appreciation of the dollar (choice B) is the opposite of the direction of overshooting.

In the United States, Where There Is a Permanent Increase