Explain the GG, MM and PPP lines and equilibrium in the Dornbusch model.

Expert Solution

In “Dornbusch Model” we try fig how the overall “price level” and “exchange rate” will be determined in an economy. So, here “GG” line show the “goods market” equilibrium which is upward sloping, => as “exchange increases”, => AD increases through increase in “export”, => domestic “P” also increases, => GG shows the goods market equilibrium in “P” and “E” frame work.

Now, the MM line shows the money market equilibrium which is downward sloping, => as “P” increases, => “real money balance” decreases, => the domestic “interest rate” increases, => exchange rate will appreciate, => negative relationship between “P” and “E”.

Now, PPP line shows the simultaneous goods and money market equilibrium. So, along the PPP line the goods and the money market is in equilibrium. Consider the following.

So, the above fig shows the “GG”, “MM” and “PPP” lines and “E1” be the equilibrium, => the equilibrium exchange rate is given by “E*” and “P*”.

Rahul Sunny answered 1 year ago

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