What explains why exchange rate changes in the short run are larger than in the long run?

Question

BlackTom AI · Accepted Answer

Speculative capital flows and investor behavior cause short-run exchange rate volatility because financial markets adjust immediately to news while goods prices and real economic variables adjust slowly.

1) Relevant knowledge points and concepts
- Exchange rates are set by supply and demand for currencies in financial markets; financial assets adjust quickly, goods and wages are sticky in the short run.
- Dornbusch’s overshooting model: with sticky prices, an unexpected monetary shock leads to an exchange-rate movement larger than its long-run change.
- Expectations, interest-rate differentials (covered/uncovered interest parity), portfolio rebalancing, liquidity and market microstructure (thin order books, leverage, herd behavior) amplify short-run moves.
- Long-run movements reflect fundamentals (relative prices, productivity, current account balance) and thus are typically smaller and smoother.

2) Step-by-step reasoning
- Step 1: New information (policy change, surprise data, risk shock) arrives.
- Step 2: Financial investors instantaneously update expected returns and rebalance portfolios, buying/selling currency positions.
- Step 3: Because goods prices and wages are sticky, the required long-run adjustment cannot occur immediately, so the exchange rate must move more than the eventual long-run change to equilibrate asset markets (overshooting).
- Step 4: Speculators’ leverage and herd trading magnify the immediate flow, producing large short-run swings.
- Step 5: Over time, as prices and fundamentals adjust, the exchange rate moves back toward its long-run equilibrium, reducing volatility.

3) Calculations / intermediate logic
No numeric calculation is necessary; the logical intermediate steps are the immediate portfolio rebalancing, overshooting due to price stickiness, and eventual mean reversion as fundamentals adjust.

4) Why the correct answer is correct
Because short-run exchange rates are determined in fast-moving financial markets dominated by investors and speculators who react to information and reposition quickly; sticky goods prices force the exchange rate to overshoot initially, producing larger short-run changes than the long-run adjustment driven by fundamentals.

5) Why other explanations are less convincing
- Purely trade-based reasons (e.g., goods trade flows) explain long-run adjustments but not rapid intraday swings.
- Inflation differentials and productivity shifts act slowly and cannot account for immediate large moves.
- Structural factors (like capital controls) limit flows rather than causing large short-run volatility.

6) Conclusion
Therefore, the best explanation is that in the short run investors and speculators drive large changes in exchange rates, matching the provided answer.

What explains why exchange rate changes in the short run are larger than in the long run?单项选择题

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