ON SLUGGISH OUTPUT ADJUSTMENT AND EXCHANGE-RATE DYNAMICS

This paper develops a model of exchange rate dynamics which incorporat es sluggish output adjustment into the Dornbusch variable output model . In this more complex system monetary expansion initially lowers inte rest rates because of sluggish output adjustment but quite surprisingl y still can produce either overshooting or undershooting of the exchan ge rate, as in the basic model. However, if undershooting occurs, the exchange rate subsequently moves away from its new long-run equilibriu m level. Furthermore, the perfect foresight exchange rate expectations scheme now contains a perversely signed parameter. Thus, variable out put does not appear to be a reasonable basis for exchange rate undersh ooting.