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    Overshooting Final 2019

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    eljosetobar
    The document summarizes Dornbusch's (1976) model of exchange rate overshooting. It shows that due to sticky prices and rational expectations, an exchange rate will initially "overshoot" and depreciate beyond its new long-run equilibrium in response to monetary shocks. Asset markets clear more quickly than goods markets. So the exchange rate adjusts to anticipate future price level changes, leading to short-run overshooting before gradual appreciation back to equilibrium. The extent of overshooting depends on expectations formation and interest rate responses. The model reconciles short-run flexibility and long-run stickiness of exchange rates.

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    Overshooting Final 2019

    Uploaded by

    eljosetobar
    101 views12 pages
    The document summarizes Dornbusch's (1976) model of exchange rate overshooting. It shows that due to sticky prices and rational expectations, an exchange rate will initially "overshoot" and depreciate beyond its new long-run equilibrium in response to monetary shocks. Asset markets clear more quickly than goods markets. So the exchange rate adjusts to anticipate future price level changes, leading to short-run overshooting before gradual appreciation back to equilibrium. The extent of overshooting depends on expectations formation and interest rate responses. The model reconciles short-run flexibility and long-run stickiness of exchange rates.

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    The document summarizes Dornbusch's (1976) model of exchange rate overshooting. It shows that due to sticky prices and rational expectations, an exchange rate will initially "overshoot" and depreciate beyond its new long-run equilibrium in response to monetary shocks. Asset markets clear more quickly than goods markets. So the exchange rate adjusts to anticipate future price level changes, leading to short-run overshooting before gradual appreciation back to equilibrium. The extent of overshooting depends on expectations formation and interest rate responses. The model reconciles short-run flexibility and long-run stickiness of exchange rates.

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    101 views12 pages

    Overshooting Final 2019

    Uploaded by

    eljosetobar
    The document summarizes Dornbusch's (1976) model of exchange rate overshooting. It shows that due to sticky prices and rational expectations, an exchange rate will initially "overshoot" and depreciate beyond its new long-run equilibrium in response to monetary shocks. Asset markets clear more quickly than goods markets. So the exchange rate adjusts to anticipate future price level changes, leading to short-run overshooting before gradual appreciation back to equilibrium. The extent of overshooting depends on expectations formation and interest rate responses. The model reconciles short-run flexibility and long-run stickiness of exchange rates.

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    © All Rights Reserved
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    of 12

    Supplementary slides in International Macroeconomics & Finance

    Exchange Rate Overshooting


    Dornbusch (1976) JPE
    Meaning of Overshooting

    Overshooting is short-run excessive b


    movement in exchange rates respect to
    long-run value. Dornbusch Keynesian
    sticky-price model show that of the c
    exchange rate would depreciate and
    ‘Overshoot’ in depreciation then appreciate a
    slowly back to the new equilibrium.

    Time

    In Dornbusch model, due to expectations Then the exchange rate does not jump
    and price rigidity the adjustment would from a to c directly, instead it first
    take the form of excessive depreciation far ‘overshoots’ to b then slowly appreciates
    beyond the equilibrium level, the exchange to the new equilibrium level in the Long
    rate ‘jumps’ from a to point b Run.
    The Model
    Basic Facts of the Model
     Assumes perfect capital mobility, it means, perfect asset substitution between
    domestic and foreign markets.
     Model is drawn on the different speeds of adjustments of the goods and asset
    (financial) markets that adjust more rapidly.
     Consistent with Rational Expectations Hypothesis REH.
     Model development based on expectations, sticky prices & capital mobility.
    I. Capital Mobility and Expectations

    r  r    ........... (1)
     Expected rate of depreciation

      ( e  e ) ....... ( 2 )
    The Expected rate of depreciation is proportional to discrepancy between Long-Run
    and current exchange rate e, the adjustment is measured by theta : 
    II. The Money Market
    Typical money market equilibrium is given in the log transformation:

    m  p   y   r ...... ( 3 )

    Long-run price equilibrium price level:

    p  m  ( r *  y ).......(5)

    combining (1),(2),(3) with manipulation, an expression linking the spot exchange


    rate as a function of current price level and the equilibrium price level, equation (6) is a
    key equation in the model.

    e  e  (1 /  ) ( p  p ) ....... ( 6 )
    III. The Goods Market

    Domestic Output demanded (D) is given by:

    ln D     (e  p )   y   r ....... ( 7 )

    Rate of increase in the price of domestic goods


    p   ln( D / Y )   [   (e  p )  (   1) y   r ] ....... (8 )

    Long-run equilibrium exchange rate

    1
    e  p    [ r *  (1   ) y   ] ....... (9 )
     
    IV. The Equilibrium Exchange Rate

    Negative relationship between prices and p


    spot exchange rate, for any given price
    level, exchange rate adjust to maintain Q p  0
    equilibrium; hence the QQ curve.
    a
    The positively sloped line show a set of
    combinations of p, e where both goods &
    markets are in equilibrium. b
    At initial point b prices are lower than
    Q
    equilibrium & exchange rate is in excess of
    the Long Run equilibrium, the path of 45°
    rising prices is accompanied by exchange
    e
    rate appreciation to its equilibrium @ a e
    The Outcomes
    Effects of monetary expansion

    An increase in nominal quantity of money p Q'


    would cause disequilibrium, this should be
    matched with either increased prices or
    Q c
    with exchange rate depreciation.

    Since Prices are sticky, and the asset a b


    market adjust rapidly comparing with the
    goods market, the exchange rate would
    Q'
    depreciate (increase) to point b and QQ
    shifts –proportionately- to the right.
    Q
    Exchange rate depreciate until the Short- 45°
    Run equilibrium b where this depreciation e' e'' e
    is enough to anticipate appreciation to e
    compensate the reduction in interest rate
    after “overshooting” to b, The exchange
    rate appreciates to the new Long-Run
    equilibrium at point c.
    Effects of monetary expansion

    M P

    Time Time

    R
    e

    Time Time
    Concluding Remarks

     Exchange rates exhibit Overshooting in depreciation before


    appreciating to equilibrium.

     The extent of overshooting depends on Expectations and


    the response of the interest rate.
    References

    I. Dornbusch, Rudiger (1976), “Expectations and Exchange


    Rate Dynamics”, Journal of Political Economy, 84(6) pp
    1161-77
    II. Hallwood, P and MacDonald, R. (2000) “ International
    Money and Finance”, 3rd edition

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