True or False?
The correct answer is False. The overshooting will be greater if the exchange rate is perceived to be a random walk because there will be no expectation that it will revert back to some long-run equilibrium level and hence no effect on the domestic interest rate. That interest rate effect would moderate the overshooting. An overshooting upward movement in the real exchange rate, for example, that led to the expectation of a subsequent decline would yield expected future capital losses for holders of domestic capital goods causing them to value those assets less in relation to earnings and leading to a rise in the domestic interest rate. This would make domestic residents willing to hold a smaller quantity of money, easing the upward pressure on the real exchange rate.