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9.2. PRICING TO MARKET 299(9.155) and (9.156) it follows that ˆP = ˆM, and ˆP ∗ = ˆM ∗ . Money istherefore neutral in the long run.Now substitute Ŝt = Ĉt − Ĉ∗ t back into (9.178) to get the solutionfor the exchange rateŜ t =[²(1 − β)+β]( ˆM t − ˆM t ∗ ). (9.184)The exchange rate overshoots its long-run value and exhibits morevolatility than the monetary fundamentals if the consumption elasticityof money demand 1/² < 1. 14 Relative prices are unaffected by thechange in the exchange rate, ˆp t (z) − ˆq t (z ∗ ) = 0. A domestic monetaryshock raises domestic spending, part of which is spent on foreign goods.ThehomecurrencydepreciatesŜt > 0 in response to foreign Þrms repatriatingtheir increased export earnings. Because goods prices are Þxedthere is no expenditure switching effect. However, the exchange rateadjustment does have an effect on relative income. The depreciationraises current period dollar (and real) earnings of US Þrms and reducescurrent period euro (and real) earnings of European Þrms. This redistributionof income causes home consumption to increase relative toforeign consumption.Real and nominal exchange rates. The short-run change in the realexchange rate isˆP t − ˆP t ∗ − Ŝt = −Ŝt,which is perfectly correlated with the short-run adjustment in the nominalexchange rate.⇐(205)Liquidity effect. If r t is the real interest rate at home, then (1 + r t )=(P t )/(P t+1 δ t ). Since ˆP t =0,itfollowsthatˆr t = −( ˆP + ˆδ t )=−(ˆδ t + ˆM)and (9.175)—(9.172) can be solved to getˆδ t =(1− β)(² − 1) ˆM, (9.185)which is positive under the presumption that ²>0. It follows that⇐(206)14 Obstfeld and Rogoff show that a sectoral version of the Redux model withtraded and non-traded goods produces many of the same predictions as the pricingto-marketmodel.