Money Illusion and Exchange Rate Dynamics in a Small Open Economy

Abstract

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 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.