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Notes On Dornbusch's Overshooting Model: ECGA 7020 Macroeconomic Theory Fall 2005

1) Dornbusch developed an open-economy model with rational expectations where output prices adjust slowly but asset markets clear instantly, allowing for exchange rate overshooting. 2) The key result is that even with perfect foresight, nominal exchange rates can overshoot their long-term value and experience excessive short-term volatility matching newly floating exchange rates. 3) The model derives laws of motion for exchange rates and prices showing their interdependence and demonstrating that exchange rates can overshoot before gradually appreciating back to equilibrium.

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108 views4 pages

Notes On Dornbusch's Overshooting Model: ECGA 7020 Macroeconomic Theory Fall 2005

1) Dornbusch developed an open-economy model with rational expectations where output prices adjust slowly but asset markets clear instantly, allowing for exchange rate overshooting. 2) The key result is that even with perfect foresight, nominal exchange rates can overshoot their long-term value and experience excessive short-term volatility matching newly floating exchange rates. 3) The model derives laws of motion for exchange rates and prices showing their interdependence and demonstrating that exchange rates can overshoot before gradually appreciating back to equilibrium.

Uploaded by

sabrina_ferrero
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
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ECGA 7020 Macroeconomic Theory Fall 2005

Notes on Dornbusch’s Overshooting Model

Rudiger Dornbusch was one of the first to explore the implications


of rational expectations for standard macroeconomic models. In 1976,
shortly after the Bretton Woods system of fixed exchange rates broke
down he published a JPE article exploring a standard open-economy IS-
LM-BP or Mundell Fleming model with rational expectations (perfect
foresight) but where output prices adjust slowly and asset markets clear
instantly. The q theory of investment offers a similar model where K
adjusts slowly but stock prices (q) can “jump” up or down instantly.

Dornbusch’s key result was that even though agents have “perfect
foresight” the nominal exchange rate can “overshoot” its long term value.
At times, for example the exchange rate depreciates sharply, only to
appreciate again at a steady rate. This excessive volatility seemed to
match the behavior of newly floating exchange rates, and it matches what
happens when an economy “jumps” onto its saddle path. The results
derived from Dornbusch overshooting model made him famous and
bolstered the rational expectations revolution in macro-economics,
despite complaints that the Mundell-Fleming model lacks micro-
foundations. Since the focus is short term price dynamics we take the
level of output is fixed ( y = y ) because our focus is on short-run
s

dynamics. Lowercase letters are the natural logarithms of the


corresponding variables denoted by uppercase letters, asterisks refers to
foreign variables. For instance. p = Ln ( P ) is the natural log of the
P
domestic price (P), and for example 
p = .
P

The version of the model developed in this handout is in continous time,


for a slightly different discrete time version of the model see see Obstfeld
and Rogoff (1996) Chapter 9 section 9.2 page 609.
I. The Dornbusch-Mundell-Fleming Model

1. Goods Market: GDP or supply of ys is fixed at some


constant, exogenous level

ys = y (1.1)

2. Demand for domestic output depends on the real exchange


rate and the real interest rate:

y d = δ ( s + p * − p) − σ (i − p ) + g , (1.2)

where s is the natural log of the nominal exchange rate (S), and i
is the nominal interest rate, p is the actual and expected rate of
inflation, g is the natural log of government spending expenditures,
while δ and σ are positive constants.

3. Price adjustment: if demand exceeds supply, inventories are


drawn down, and the prices increase in proportion to excess
demand. This is a standard Phillips curve ( Obstfeld and Rogoff
(1996) section 9.2 use an expectations augmented Phillips curve)

p = α ( y d − y ) . (1.3)

4. The asset market is a standard LM money demand schedule,

m − p = φ y − λi , (1.4)
where m is the natural log of nominal money supply M, φ and λ
are positive constants.
5. Last, assume uncovered interest parity:

i = i * + s (1.5)
Other Assumptions:

• i* is exogenous and constant.


• m, g and p* remain constant over time, therefore we have three time-
dependent variables: s, p and i.

I. Deriving the law of motion for exchange rates and prices

Using money demand equation (1.4) we solve for i,


φy−m+ p
i= (1.6)
λ
and then substitute this expression into (1.5) to get the law of
motion for the nominal exchange rate,

φy−m+ p
s = i − i* = −i*
λ . (1.7)
When s = 0 then p = i * λ + m − φ y , and note that

∂s 1
= >0
∂p λ

Substituting (1.2) into (1.3) and solving for p , we have:


α
p = [δ ( s + p * − p ) − σ i + g − y ] . (1.8)
1 − ασ
Next substitute (1.6) into (1.8) and to get the law of motion for p,

α σ φy−m
p = {δ ( s + p*) − (δ + ) p − σ + g − y}
1 − ασ λ λ
. (1.9)
When p = 0 then,

1 φy−m
p= {δ ( s + p*) − σ + g − y}
σ λ ,
(δ + )
λ

Implying that

∂p δ
= > 0 ∂p = αδ > 0
∂s σ , ∂s 1 − ασ
(δ + )
λ
σ
−α (δ + )
∂p λ <0
=
and ∂p 1 − ασ

these equations are helpful for interpreting the graphical solution


of the model.

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