Question

(a) Explain the causes of exchange rate overshooting in the Dornbusch model when there is an increase in the money supply. Provide an intuitive explanation as well. (b) Critically discuss the assumptions of the basic Dornbusch model. (c) Without going into the full analytic details, explain why an assumption of rational expectations will lead to a similar intuitive explanation as in (a). (c) Explain the suggested Frankel modification to the model. What are the testable implications of this modification?

Answer 1

Dornbush Model of Overshooting

According to the Dornbusch this model, in the short run due to the assumption of sticky prices when there is a change in the monetary policy, there is an extreme volatility of nominal exchange rate going beyond the long run level. This Extreme volatility is explained by the term Overshooting.

Also considered as dynamic version of Mundel-Flemeing model, it is based on the observation, that adjustment in foreign currency market is very fast and adjustment in product market is sluggish.

a) If there is an increase in money supply the following events takes place:

· In the Long run: We know that output is at full employment level and prices are flexible. An increase in money supply leads to an increase in AD. This causes an equal increase in the price level that makes the real money supply same as before (M/P). Thus there in no effect on real exchange rates, output, real incomes and interest rates.

· In the short run:

- Prices are sluggish to vary and are sticky. An increase in the money supply leads to an increase in the real money supply (M/P). This can be explained by a rightward shift of the LM curve in the money market.

- This would cause in decrease in the interest rate. Thus the domestic rate of interest will fall below the world rate of interest. This means, the return on domestic assets and securities would be lower than the return on foreign assets and securities, leading to a state of disequilibrium in the short-run (in market of assets).

- The equilibrium in the asset market is only possible if there is an expected appreciation of exchange rate to the extent equal to the difference between the domestic interest rates and the world interest rates.

- The nominal exchange rate can fall to its expected and higher level only if in the short run it rises to a greater extent than its long run equilibrium level. As we know the exchange rate adjusts more rapidly than the price level, hence in the short-run the rate of exchange increase to a much higher level, without price level being changed. This concept is termed as exchange rate overshooting.

b) Assumptions of the basic model are as follows:

- Small Open Economy: Which means the company’s capital market is small as compared to the capital market in Rest of the world. Because of this it faces the interest rate as given which is equal to the world interest rate.

- Perfect Capital Mobility: It ensures that that the return on the domestic assets/securities is equal to the return on the foreign assets/securities. This leads to the holding of the condition of interest parity. Thus, here domestic currency assets and foreign currency assets are perfect substitutes.

- Prices of imports are given: As the economy is small, the world prices of imports are given. Since domestic output and imports are not perfect substitutes, the domestic prices are given by the domestic aggregate demand of those goods. Here both absolute and relative prices in terms of imports are demand by the domestic demand.

Which mean, R = EP* / P, where,

R = Real exchange rate

E= Nominal Exchange Rate

P = Domestic Price

P* = Foreign Price

- Output is given : The output in the economy is given and is at full employment level. Here, all the resources are fully employed and the unemployment rate is at its natural.

- Good Prices are Sticky in the short run, but changes in the long run – According to this, Aggregate Supply will be horizontal in short run, but could be vertical in the long-run (not affected by price level changes).

- Flexible Exchange rate – Prices are determined by the flexible exchange rate, which ensures that purchasing power parity condition holds.

- There is equilibrium in both the goods market and money market. All agents are risk neutral.

c) The Dornbusch model of overshooting assumes that the agents in this model have perfect foresight when they forecast exchange rates. Perfect foresight is a very special case of rational expectation hypothesis which is also called as deterministic expectations.

Thus expected value of depreciation of the Exchange Rate will be equal to the actual deprecation of the exchange rate, without any error component.

d) As per Frankel’s modification of the Dornbusch Model:

He allowed a finite speed adjustment in the money market and foreign currency market, unlike the Dornbush assumptions. Under this situation, the short-run effects of the monetary expansion would depend upon the degree of capital mobility. So as per this assumption:

- If Capital mobility is high : Exchange Rate overshoots its long-run value

- If Capital mobility is low : Exchange Rate would even undershoot its long run value