Testing the absorber hypothesis of exchange rates for the overshooting of agricultural prices in China

Abstract

This study aims to test the overshooting effect of agricultural prices and the absorber hypothesis of exchange rates by extending the existing overshooting model. Using a combination of modern time series methods and monthly aggregate data from China, we demonstrate that overshooting of agricultural prices does indeed occur since the impact of monetary expansion on flexible agricultural prices is significantly larger than on relatively sticky industrial prices. Granger causality tests confirm that monetary expansion is a possible determinant of the movements of both agricultural and industrial prices, thus providing a solid empirical foundation for the overshooting hypothesis. Our findings also confirm the absorber hypothesis, in that the overshooting effect of agricultural prices under a fixed exchange rate regime (ERR) is shown to be greater than that under a floating ERR. The main policy implication is that policymakers should pay attention to the spillover effect of monetary expansion on agricultural prices when adjusting macroeconomic policies, especially under a fixed ERR.