Open Economies Review

, Volume 4, Issue 1, pp 5–26 | Cite as

Long-run consequences of finite exchange rate bubbles

  • Alessandra Pelloni
Article
  • 27 Downloads

Abstract

This paper draws on the literature on exchange rate instability and on sunk-cost hysteresis to analyze the long-run effects of exchange rate bubbles. To address the issue, after discussing the implications of sunk-cost hysteresis for aggregate supply, we propose two versions of the Dornbusch (1976) model of exchange rate determination. We modify it so as to allow for endogenous adjustment in productive capacity, with the aggregate investment function being linear with respect to the exchange rate in one version and non-linear in the other. For both versions, we provide solutions for a Blanchard-type bubble developing on the foreign exchange market. We find that, if capacity adjusts non-linearly, such a bubble will affect the steady state of the economy.

Key words

exchange-rate bubbles sunk-cost hysteresis 

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Copyright information

© Kluwer Academic Publishers 1993

Authors and Affiliations

  • Alessandra Pelloni
    • 1
    • 2
  1. 1.University of Rome, Tor VergataItaly
  2. 2.European University InstituteFlorence

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