The asset market approach to exchange rate determination: Some short-run,stability, and steady-state properties

This paper develops a dynamic macro model embodying the asset market view of exchange rate determination, looking at both the short run and steady state, as well as the stability of the system under alternative financial policies. The short-run and long-run effects of an expansionary monetary policy are discussed in detail, with particular attention being devoted to the overshooting of the short-run exchange rate to such a disturbance. It is shown how, in the short run, either overshooting or undershooting may occur, depending upon a variety of factors relating to: 1) the fraction of wealth held in the form of foreign bonds; 2) the magnitudes of wealth effects in the various asset demand functions; and 3) the degree of substitutability between domestic and foreign securities.