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Exchange Rate Overshooting Dornbusch (1976) JPE

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Supplementary slides in International Macroeconomics & Finance. Exchange Rate Overshooting Dornbusch (1976) JPE. Jarir Ajluni - July 2005. Time. Meaning of Overshooting.

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slide1
Supplementary slides in International Macroeconomics & Finance

Exchange Rate Overshooting

Dornbusch (1976) JPE

Jarir Ajluni - July 2005

meaning of overshooting
TimeMeaning of Overshooting

Traditional and monetarists views suggest that after a monetary expansion, prices rise, interest rates falls and consequently the exchange rate is to depreciate (increase), Dornbusch Keynesian sticky-price model show that of the exchange rate would depreciate and ‘Overshoot’ in depreciation then appreciate slowly back to the new equilibrium.

b

c

a

In Dornbusch model, due to expectations and price rigidity the adjustment would take the form of excessive depreciation far beyond the equilibrium level, the exchange rate ‘jumps’ from a to point b

Then the exchange rate does not jump from a to c directly, instead it first ‘overshoots’ to b then slowly appreciates to the new equilibrium level in the Long Run.

slide4
Expected rate of depreciation

The Expected rate of depreciation is proportional to discrepancy between Long-Run and current exchange rate e, the adjustment is measured by theta :

  • Consistent with Rational Expectations Hypothesis REH.
  • Model development based on expectations, sticky prices & capital mobility.
  • Model is drawn on the different speeds of adjustments of the goods and asset (financial) markets that adjust more rapidly.
  • Assumes perfect asset substitution between domestic and foreign markets.

Basic Facts of the Model

I. Capital Mobility and Expectations

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II. The Money Market

Typical money market equilibrium is given in the log transformation:

combining (1),(2),(3) with manipulation, an expression linking the spot exchange rate as a function of current price level and the equilibrium price level, equation (4) is a key equation in the model.

III. The Goods Market

Domestic Output demanded (D) is given by:

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p

Q

Q

45°

e

IV. The Equilibrium Exchange Rate

Negative relationship between prices and spot exchange rate, for any given price level, exchange rate adjust to maintain equilibrium; hence the QQ curve.

a

The positively sloped line show a set of combinations of p, e where both goods & markets are in equilibrium.

b

At initial point b prices are lower than equilibrium & exchange rate is in excess of the Long Run equilibrium, the path of rising prices is accompanied by exchange rate appreciation to its equilibrium @ a

effects of monetary expansion
Q'

p

Q

Q'

Q

45°

e

Effects of monetary expansion

An increase in nominal quantity of money would cause disequilibrium, this should be matched with either increased prices or with exchange rate depreciation.

c

Since Prices are sticky, and the asset market adjust rapidly comparing with the goods market, the exchange rate would depreciate (increase) to point b and QQ shifts –proportionately- to the right.

a

b

Exchange rate depreciate until the Short-Run equilibrium b where this depreciation is enough to anticipate appreciation to compensate the reduction in interest rate after “overshooting” to b,The exchange rate appreciates to the new Long-Run equilibrium at point c.

e'

e''

concluding remarks
Concluding Remarks
  • Exchange rates exhibit Overshooting in depreciation before appreciating to equilibrium.
  • The extent of overshooting depends on Expectations and the response of the interest rate.
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Dornbusch, Rudiger (1976), “Expectations and Exchange Rate Dynamics”, Journal of Political Economy, 84(6) pp 1161-77
  • Hallwood, P and MacDonald, R. (2000) “ International Money and Finance”, 3rd edition

References

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