Money Illusion and Exchange Rate Dynamics in a Small Open Economy

Chung-Fu Lai
2015 Research in World Economy  
This paper investigates the role of money illusion on exchange rate dynamics in a small open economy. We find that whether the exchange rate overshoots in response to a monetary shock is not depend on the parameters such as the consumption elasticity of money demand and the degree of openness proposed by Lane (1997) , but the phenomenon of money illusion, this is because the degree of correlation between money demand and consumption is lower with the existence of money illusion, hence the
more » ... on, hence the exchange rate must present the excessive adjustment in order to re-achieve the new equilibrium position of the money market, exchange rate overshooting takes place.
doi:10.5430/rwe.v6n1p199 fatcat:k5tjotqs2fh6zpzjgmjfm7slau