Question

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

Purchasing Power Parity, and, Monetary Models of Exchange Rates

The rate at which currency of one country would have to be converted into the currency of another country, to buy the same amount of services, and, goods in another country. A commonly used instance is the price of a hamburger. This cross-country comparison is known as "Big Mac" index. PPP exchange rates stay stable over time. Market rates are volatile. Using these could produce large swings. PPP is regarded as a better measure of overall well-being. It takes into account differences in prices of non-traded goods.

Dornbusch worked on the sticky price monetary model. Frenkel and Mussa worked on the flexible prices. Flexible price model assumes PPP holds, and, that the prices of goods are flexible. The real exchange rate is constant over time. Sticky price model assumes PPP holds only in the long-run. This model allows substantial overshooting, for real-price adjusted exchange rates, and, nominal exchange rates.

The exchange rate is expressed as a present discounted value of future, and, current fundamentals.

b is the discount factor.

F_t economic fundamentals

I_{t represents the information set of agents}