Dornbusch Model

Topics: Inflation, Economics, Macroeconomics Pages: 7 (1383 words) Published: April 15, 2015


Professor: Thomas Gries. Course: International Finance &Exchange Rates.
Paula de Cobos García.
Winter Semester 2014/15.

1. Write down the Dornbusch Overshooting Model: central elements with the according equations.

“In a very influential paper Dornbusch (1976) developed a model to explain Exchange rate overshooting, a phenomenon which occurs when, during the adjustment to new equilibrium, Exchange rates temporarily overshoot their long run values. This can explain what appears to be excessive volatility in Exchange rates. The novel feature of the model is the explicit treatment of differential speeds of adjustment in the goods and asset markets. Asset markets adjust quickly, almost instantaneously to shocks, while goods markets are sluggish, and adjustment is slow”. The Dornbusch Model is a hybrid, it combines the short run features as the Mundell-Fleming model, which it not takes no account of expectations and the price level is fixed; and the long-run characteristics of the monetary model. What Professor Rudiger Dornbush could observe during his exploration was that while product markets adjust only slow, financial markets appear to adjust far more rapidly-almost instantaneously, in fact. The consequence of the real world is that financial markets have to over-adjust to perturbations, for compensating the stickiness of prices in goods markets. As a consequence of the delayed of the beginning of product prices, the interest rate, aggregate demand and the real Exchange rate return to their original values. Like in the monetary model, all the real magnitudes ends where they started, and the nominal Exchange rate at a new long-term level that reflects the proportionate change in the money supply. One characteristic of the overshooting model is that is likely to respond to a real perturbation. Dornbusch model has some appeal because of the following reasons: 1. It is a model that is at once simple, elegant and readily understood. 2. While analysing the effect of a monetary expansion, an important distinction is made between an initial phase during which only financial variables adjust and a later phase during which the real economy begins to adjust. A monetary expansion in Dornbusch’s model will instantly adjusts interest rates and exchange rates; later the price level begins to respond to the monetary expansion. 3. This model assume that the public’s expectations about exchange rates are fully rationally formed. This implies that observing an increase in the money stock, they can also know the end result, they can also know the time path of adjustment of the economy towards this end point. In the short-run, they have perfect foresight. 4. According to what Dornbusch said, the only real adjustment that occurs in the later stages is the price adjustment. 5. Dornbusch shows that the exchange rate must initially overshoot its long-run level. It is also where we frequently observe what looks like excessive exchange rate movement. 6. Dornbusch assumes that prices are sticky in the short-run but ultimately adjust fully to the increase in the money stock. At the same time, Dornbusch’s long-run results are that prices will increase in proportion, that interest rates will return to their original levels and that the currency will also devalue in proportion. B. EQUATIONS.

a) Short term and at any time:
1. Real demand for goods: yd = h (s - p) = h (q) q≡ s – p (real exchange rate). The equation captures the essential link between aggregate demand for domestic output and the real exchange rate. As we know, the higher the real exchange rate, the more competitive are UK products and henceforward the greater the demand. 2. Demand adjustment: ṗ = π (yd - ȳ) ȳ constant.

This equation says that the broader the gap among demand and...
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