Question

Purchasing Power Parity and Monetary Models of Exchange Rates

How does the Dornbusch overshooting model indicate exchange rate volatility and large exchange rate movements? What problems may this create based on the role of expectations on current exchange rate movements due to monetary policy, and the role of exchange rate movements in asset prices?

Answer 1

In Dornbusch's view, excessive exchange rate volatility was the inevitable result of the chaotic monetary policies that had led to the breakup of fixed rates in the first place. If domestic monetary policies are unpredictable, then so, too, will be domestic inflation differentials. Ergo, the exchange rate must be volatile because, in the very long run, there has to be a tight link between national inflation differentials and exchange rates. (At least, this is what we have all believed since Swedish economist Gustav Cassel championed his theory of "purchasing power parity"—that exchange rates adjust to reflect differences in consumer price levels—as the way to reset world exchange rates after the system broke down during World War I.)

If Dornbusch had merely pointed out that monetary policy had lost its way in the 1970s, he would have been regarded as sensible but not necessarily brilliant. The stroke of genius in his paper was "overshooting." According to Dornbusch's now famous logic, monetary policy volatility is not only reflected in exchange rate volatility but is also amplified. The core idea is that the sluggishness of domestic prices and wages forces the exchange rate to be the shock absorber for monetary policy. Dornbusch's theory, which he spiced up by incorporating the exciting new theory of "rational expectations"—when private agents form exchange rate expectations based on reasoned and intelligent examination of available economic data—suggested that modest improvements in monetary stability would be rewarded with large gains in exchange rate stability.

The new world of flexible exchange rates was too young in 1976 to provide enough data to meaningfully test what is now often labeled the Mundell-Fleming-Dornbusch model. Nobody really cared. It was a beautiful theory, and Dornbusch's new view of flexible exchange rates reinvigorated the field. Recall the well-worn quip that "an economist is someone who sees something in practice and asks if it is possible in theory." His model gave reassurance that there might be some logic to the apparent randomness of flexible exchange rates, and maybe even a cure for volatility. Students, who had for more than a decade rejected the field of international finance as moribund, flocked to it starting in the mid-1970s. Dornbusch's very difficult and confrontational graduate classes at the Massachusetts Institute of Technology (MIT) were populated by the likes of Lawrence Summers, Paul Krugman, and Jeffrey Sachs