Is the Honeymoon Effect Valid in the Presence of Both Exchange Rate and Output Expectations? A Graphical Analysis

Abstract

This paper sets up a modified Mundell-type economy embodying a New Keynesian “forward-looking” exchange-rate and output expectations, and develops a graphical exposition to explain the conflicting outcome between Krugman`s (1991) prediction and the empirical observations in the regime of exchange rate target zones. We find that Krugman`s (1991) honeymoon effects stem from his emphasis on exchange-rate expectations. If both exchange-rate expectations and output expectations are brought into the picture, they will then generate two conflicting effects to the realization of the nominal exchange rate, and hence the honeymoon effect may not exist.