Question

If the central bank increase money supply unexpectedly, based on Dornbusch’s exchange rate determination model discuss what will happen to the economy.

Answer 1

If the central bank increase money supply unexpectedly, based on Dornbusch’s exchange rate determination model, foreign exchange rate will temporarily overreact to changes in monetary policy to compensate for sticky prices of goods in the economy.

The overshooting model or exchange rate overshooting hypothesis given by Dornbusch explains high levels of exchange rate volatility. According to the model, when a change in monetary policy occurs (e.g., an unanticipated permanent increase in the money supply), the market will adjust to a new equilibrium between prices and quantities.

Initially, because of the "stickiness" of prices of goods (tendency of prices to remain constant or to adjust slowly despite changes in the cost of producing and selling the goods or services), the new short run equilibrium level will first be achieved through shifts in financial market prices. Then, gradually, as prices of goods "unstick" and shift to the new equilibrium, the foreign exchange market continuously changes, approaching its new long-term equilibrium level. Only after this process has run its course will a new long-run equilibrium be attained in the market.

As a result, the foreign exchange market will initially overreact to a monetary change, achieving a new short run equilibrium. Over time, goods prices will eventually respond, further allowing the foreign exchange market to slow down a bit, and the economy to reach the new long run equilibrium in all markets.