Why Are G-3 Exchange Rates So Fickle?
Last November, at the IMF’s Second Annual Research Conference, it was my good fortune to be able to pay tribute to the twenty-fifth anniversary of Rudiger Dornbusch’s famed “overshooting” model of exchange rates. Dornbusch’s 1976 paper became an instant classic because it seemed to make sense of the chaotic new world of flexible exchange rates, which had only just replaced the serene “Bretton Woods” system of fixed rates. In Dornbusch’s view, excessive exchange rate volatility was the inevitable result of the chaotic monetary policies that had led to the breakup of fixed rates in the first place. If domestic monetary policies are unpredictable, then so, too, will be domestic inflation differentials. Ergo, the exchange rate must be volatile because, in the very long run, there has to be a tight link between national inflation differentials and exchange rates. (At least, this is what we have all believed since Swedish economist Gustav Cassel championed his theory of “purchasing power par
