Dornbusch Model M-F Model: with fixed prices policy conclusions are valid only in short run, . Price level is sticky: AS is horizontal in SR (impact phase). Dornbusch model dr hab. o Long-run features of the flexible price model (e.g. economy is at Short-run sticky prices are represented by a Phillips curve type. Dornbusch’s influential Overshooting Model aims to explain why floating The assumption of long-run PPP is made because prices are ‘sticky’ in the short run.

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It is a great honor to pay tribute here to one of the most influential papers written in the field of International Economics since World War II. Rudiger Dornbusch’s masterpiece, “Expectations and Exchange Rate Dynamics” was published twenty-five years ago in the Journal proce Political Economyin The “overshooting” paper-as everyone calls it-marks the birth of modern international macroeconomics.

There is little question that Dornbusch’s rational expectations reformulation of the Mundell-Fleming model extended the latter’s life for another twenty-five years, keeping it in the forefront of practical policy analysis.

This lecture is divided into dotnbusch parts. First, I will try to convey to the reader a sense of why “Expectations and Exchange Rate Dynamics” has been so influential. My goal here is not so much to offer a comprehensive literature survey, though of course there has to be some of that.

### Overshooting model – Wikipedia

Rather, I hope the reader will gain an appreciation of the paper’s enormous stature in the field and why so much excitement has always surrounded it. The second part of the lecture is a more detached discussion of the empirical evidence for and against the model, and a thumbnail sketch of the model itself.

The final section touches on competing notions of overshooting. One of the first words that modeo to mind in describing Dornbusch’s overshooting paper is ” elegant “. Policy economists prife understandably cynical about academics’ preoccupation with theoretical elegance. But Dornbusch’s work is a perfect illustration of why the search for abstract beauty can sometimes yield a large practical payoff. Eticky is precisely the beauty and clarity of Dornbusch’s analysis that has made it so flexible and useful.

Like great literature, Dornbusc can be appreciated at many levels. Policymakers can appreciate its insights without reference to extensive mathematics; graduate students and advanced researchers found within it a rich lode of subtleties. A second word to describe the work is ” path breaking “.

I will offer some quantitative evidence later, but suffice to say here that literally scores of Ph. It is not hyperbole to say that Dornbusch’s mldel view of floating exchange rates reinvigorated a field that was on its way to becoming moribund, using only dated, discredited models and methods. Dornbusch inspired fresh thinking and orice in fresh faces into the field. Obstfeld’s paper spans the whole modern history of international macroeconomics, from Meade to “New Open Economy Macroeconomics”, but the main emphasis is on Bob Mundell’s papers.

I, and perhaps many other readers, found Obstfeld’s discussion enlightening in part because we do stickyy have the same intimate knowledge of Mundell’s papers that we do of Dornbusch Mundell’s profoundly original ideas are, of course, at the core of many things we do in modern international finance, and he was the teacher of many important figures in the field including Michael Mussa, Jacob Frenkel, and Rudiger Dornbusch.

Mundell is a creative giant who was thinking about a single currency in Europe back when intergalactic trade seemed like a more realistic topic for research. But the methods and models in Mundell’s papers are now badly dated, and are not always easy to digest for today’s reader even if at the time they seemed a picture stikcy clarity compared to the existing state of the art, Meade One of the remarkable features of Dornbusch’s paper is that today’s graduate students can still easily read it in the original and, as I will document, many still do.

The reader should understand that as novel as the overshooting model was, Dornbusch was hardly writing in a vacuum. Jo Anna GrayStanley Fischerand Ned Phelps and John Taylor were all working on closed economy sticky-price rational expectations models at around the same time. Stanley Dorbbusch had already introduced rational expectations to international macroeconomics.

Dornbusch’s Chicago classmate Michael Mussa my predecessor as Economic Counsellor at the Fund was also working actively in the area kodel the time, though he delayed publication of his main piece on the topic until Mussa There were others who were fishing in the same waters as Dornbusch at around the same time, e.

But the elegance and clarity of Modsl model, and its obvious and immediate policy relevance, puts his paper in a separate class from the other international macroeconomics papers prrice its time.

Pric word about New Open Economy Macroeconomics, which Obstfeld surveyed last year; certainly this literature has come to fornbusch the academic literature on international macroeconomic policy. At the same time, however, they can be viewed as direct descendants. Formally, New Open Economy Macroeconomics attempts to marry the empirical sensibility of the sticky-price Dornbusch model with the elegant but unrealistic “intertemporal approach to the current account”.

But even with the inevitable onslaught of more modern approaches, the Dornbusch model is still very much alive today on its own, precisely because it is so clear, simple and elegant. If one is in a pinch and needs a quick response to a question about how monetary policy might affect the exchange rate, most of us will still want to check any answer against Dornbusch’s model. Dornbusch’s variant of the Mundell-Fleming paper is stickky just about overshooting.

The general approach has been applied to a host of different problems, including the “Dutch disease,” the choice of exchange rate regime, prce price volatility, and the analysis of disinflation in developing countries. It is a framework for thinking about international monetary policy, not simply a model for understanding exchange rates.

But what sold the paper to policymakers, what still sells the paper to graduate students, fornbusch overshooting. One has to realize that at the time Dornbusch was writing, the world had just made the transition from fixed to flexible exchange rates, and no one really understood what modrl going on. Contrary to Friedman’s rosy depiction of life under floating, exchange rate changes did not turn out to smoothly mirror international inflation differentials.

Instead, they were an order of magnitude more volatile, far stickyy volatile than most experts had guessed they would be. Along comes Dornbusch who lays out an incredibly simple theory that showed how, with sticky prices, instability in monetary policy-and monetary policy was particularly unstable during the mids-could be the culprit, and to a far greater degree than anyone had imagined.

Dornbusch’s explanation shocked and delighted researchers because he showed stikcy overshooting did not necessarily grow out of myopia or herd behavior in markets. Rather, exchange rate volatility was needed to temporarily equilibrate the system in response to monetary shocks, because underlying national prices adjust so slowly.

As we shall see, Dornbusch’s conjecture about why exchange rates overshoot has proven of relatively limited donbusch empirically, zticky a plausible case can be made that it captures the effects of major turning points in monetary policy.

But the true strength of the model lies in that it highlights how, in today’s modern economies, one needs to think about the interaction of sluggishly adjusting goods markets and hyperactive asset markets. This broader insight certainly still lies at the core of modern thinking about exchange rates, even if the details of our models today differ quite a bit.

Paul Samuelson once remarked that there are very few ideas in economics that are both a true and bnot obvious. Dornbusch’s overshooting paper is certainly one of those rare ideas. Now, of course, unless one is steeped in recent economic theory, little of what appears in stikcy professional economics journals will seem obvious.

However, that is only because it takes constant training and retooling to be able to follow the assumptions in the latest papers. Once you can understand the assumptions, what follows is usually not so surprising. But this is certainly not the case with the “overshooting” result, as I will now briefly illustrate.

## Overshooting model

Since this lecture ;rice aimed at a broad audience, it is not my intention to invoke too many mathematical formulas, though there will be a few. A small number of equations is necessary if only to impress upon the reader how simple the concept really is.

The reader can easily skip over them.

Two relationships lie at the heart of the overshooting result. The first, equation 1 below, is ,odel “uncovered interest parity” condition.

That is, if home and foreign bonds are perfect substitutes, and international capital is fully mobile, the two bonds can only pay different interest rates if agents expect there will be compensating movement in the exchange rate.

Indeed, Dornbusch assumed “perfect foresight” in his model-essentially that there was no uncertainty-since techniques for dornbuscch uncertainty were not dornbsch fully developed at the time of his writing; the distinction between perfect foresight and rational expectations is not consequential for our analysis here.

Does uncovered interest parity really hold in practice? Many a paper has been written on the topic, and the short answer is no, not exactly. Several recent attempts to reconcile exchange rate theory and data turn on generalizing this equation, though it remains to proven how fruitful this approach will be. Higher interest rates raise the opportunity cost of holding money, and thereby lower the demand for money. Conversely, an increase in output raises the transactions demand for money.

Finally, the demand for money is proportional to the price level. Equation 2 is a simple variant of the Goldfeld money demand function. Given the enormous revolution in transactions technologies, there has been a rethinking of money demand functions in recent years, but not in any direction that requires us to completely redo Dornbusch’s setup.

So how does “overshooting” work? It can all be captured by combining equations 1 and 2 with a few simple assumptions. Odrnbusch, assume that the domestic price level p does not move instantaneously in response to unanticipated monetary disturbances, but adjusts pice slowly over time.

We shall say more about pfice assumption shortly, but it mdoel certainly empirically realistic. As Mussa so convincingly demonstrated, domestic price levels generally have the cardiogram of a rock compared to floating exchange rates, at least in countries with trend inflation below, say, percent per annum.

Second, assume that output y is exogenous what really matters is that it, too, dornbsuch sluggishly in response to monetary shocks. Third, we will assume that money is neutral in the long run, so that a permanent rise in m leads a proportionate rise in e and pin the long run.

Now suppose, following Dornbusch’s famous thought experiment, that there is an unanticipated permanent increase in the money supply m. If the nominal money supply rises but the price level is temporarily fixed, then the supply of real balances m-p must rise as well.

To equilibrate the system, the demand for real balances must rise. Since output y is assumed fixed in the short run, the only way that the demand for real balances can go up is if the interest rate i on domestic currency bonds falls. According to equation 1it is possible for i to fall if and only if, over the future life of the bond contract, the home currency is expected to appreciate.

But how is this possible if we know that the long run impact of the money supply shock must be a proportionate depreciation in the exchange rate? Dornbusch’s brilliant answer is that the initial depreciation of the exchange rate must, on impact, be larger than the long-run depreciation. This initial excess depreciation leaves room for the ensuing appreciation needed to simultaneously clear the bond and money markets.

The exchange rate must overshoot. Note that this whole result is driven by the assumed rigidity of domestic prices p. Otherwise, as the reader may check, e, p, and m would all move proportionately on impact, and there would be no overshooting. Put differently, money is neutral here if all nominal quantities, including the price level, are fully flexible.

Of course, I have left out a lot of details, and we need to check them to make sure that this story is complete and hangs together. We will do it later. Fundamentally, however, the power and generality of the overshooting idea derives precisely from the fact that it can be cooked with so few ingredients. The only equations we need are 1 and 2and therefore the result is going to obtain across a broad class of models that incorporate sticky prices.

Now underlying Dornbusch’s disarmingly simple result lies some truly radical thinking.

At the time Rudi was working on his paper, the concept of sticky prices was under severe attack. In his elegant formalization of the Phelps islands model, Lucas suggested that one could understand the real effects of monetary policy without any appeal to Keynesian nominal rigidities, and byLucas had many influential followers in Sargent, Barro and others. The Chicago-Minnesota School maintained that sticky prices were nonsense and continued to advance this view for at least another fifteen years.

It was the dominant view in academic macroeconomics.