Short‐Run and Long‐Run Dynamics of Exchange Rates with Sticky Prices

This paper constructs microfoundations for the nexus between sticky goods prices and exchange rate overshooting. Based on an asset‐pricing model, this paper describes how the exchange rate responds to a monetary shock in the short run and adjusts in later periods to a new long‐run rate. In an environment where goods prices are sticky, the short‐run response of the exchange rate to a monetary shock depends on the elasticity of consumption demand. The long‐run exchange rate always shifts equiproportionately to a monetary shock regardless of the parameter values and is reached many periods after the shock.