Suppose that a monetary model describes the long-run behavior of the nominal exchange rate well, but fails to describe the short-run behavior; specifically, in the short run large deviations from purchasing power parity are observed due to nominal rigidities in goods' prices and overshooting of the nominal exchange rate in response to monetary shocks occurs as a result.
a) What are the three key modeling assumptions used to derive the monetary model of exchange rates? What is the only one of these modeling assumptions which is different in the Dornbusch over-shooting model?
b) Write down an equation that reflects the nominal exchange rate solution provided by the monetary model i.e. expresses the nominal exchange rate as a function of monetary and real fundamentals and expectations of the future exchange rate and explain each term.
c) Use diagrams and words to describe the impact of a permanent home money supply shock for
i) the nominal exchange rate
ii) the home interest rate, and
iii) the home price level
in the short run (according to the Dornbusch overshooting model) and in the long run (according to the monetary model). Explain carefully why the differences in prediction arise in each case.
d) What do each of these two models imply about the ability of monetary policy to influence interest rates and aggregate demand/output in an open economy?