The Niehans paradox,flexible exchange rates,and macroeconomic stability

This paper re-examines Dornbusch's suggestion that monetary expansion under a floating rate system will not cause a temporary decline in economic activity — the Niehans paradox — because households will cut their saving to maintain consumption spending on domestic goods. Despite this terms of trade effect on saving, it turns out that devaluation in the standard Keynesian model, in which trade flows, however, respond to the exchange rate with a simple distributed lag, produces a temporary decline in economic activity under certain plausible conditions. Consequently, the Niehans paradox still can arise if domestic expenditures respond sluggishly to lower interest rates.