Dornbusch Model M-F Model: with fixed prices policy conclusions are valid only in short run, . Price level is sticky: AS is horizontal in SR (impact phase). Dornbusch model dr hab. o Long-run features of the flexible price model (e.g. economy is at Short-run sticky prices are represented by a Phillips curve type. Dornbusch’s influential Overshooting Model aims to explain why floating The assumption of long-run PPP is made because prices are ‘sticky’ in the short run.

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The only equations we need are 1 and 2and therefore the result is going to obtain across a broad class of models that incorporate sticky prices.

Theory and Empirics A. Now suppose, following Dornbusch’s famous thought experiment, that there is an unanticipated permanent increase in the money supply m.

Overshooting model

As one can see, the exchange rate must overshoot its long-run equilibrium. It is better suited than Dornbusch’s original formulation to dealing with more complex exogenous shocks processes. Rather, I hope the reader will gain an appreciation of the paper’s enormous stature in the field and wticky so much excitement has always surrounded it.

According to the model, when a change in monetary policy occurs e. In equilibrium, [9] hold, that is [6] – [9] is the difference from equilibrium. The Overshooting Model in Perspective One of the first words that pricee to mind in describing Dornbusch’s overshooting paper is ” elegant “.

To take the model to the data, one needs to resolve many issues. Along comes Dornbusch who lays morel an incredibly simple theory that showed how, with sticky prices, instability in monetary policy-and monetary policy was particularly unstable during the mids-could be the culprit, and to a far greater degree than anyone had imagined.

As one can see, the model does seem to say something about major turning points, though we will not press to see if it robustly passes regression tests.


One of the remarkable features of Dornbusch’s paper is that today’s graduate students can still easily read it in the original and, as I will document, many still do. There is little question that Dornbusch’s rational expectations reformulation of the Mundell-Fleming model extended the latter’s life for another twenty-five years, keeping it dornbbusch the forefront of practical policy analysis.

Aggregate demand is prjce by the standard open economy IS-LM mechanism.

In the generalized model, the Dornbusch type overshooting mechanism is the primary factor driving the short-run results though there need not be overshooting depending on the model setup and parameters. First, because we can actually solve the model formally, it is possible not only to talk about overshooting from a qualitative perspective, but from a quantitative perspective.

The new view can be found in many places, but certainly in the closed economy work of authors such as Rotemberg and WoodfordWoodfordand of course in New Open Economy Macroeconomics. Rejecting this view, Dornbusch argued that volatility is in fact a far more fundamental property than that.

For future generations reading this lecture, I will note that the mark was Germany’s currency before the euro. The day when Dornbusch presented sticjy overshooting paper was different. Views Read Edit View history. Oh, yes, as an afterthought, I should note that Dornbusch’s article has also been cited in 40 different articles in the American Economic Review and the Journal of Political Economythe leading professional economics journals.

But if it is not at this intersection, then it must lie on the line marked by arrows, as any other starting sticjy will lead down a path in which the exchange rate either explodes or collapses, even if the money supply remains constant.

Sitting beside the MIT students, there were also many Ph. The solid line gives the real exchange rate, and the dashed line is the one-year real interest differential. Obstfeld and Stockman discuss these models in their Handbook of International Economics chapter, and I will leave the reader to look there for further details and references.

At or around the time of Dornbusch’s writing, Kouri and Calvo and Rodriguez were proposing a very different notion of overshooting. Jo Anna GrayStanley Fischerand Ned Phelps and John Taylor were all working on closed economy sticky-price rational expectations models at around the same time. Therefore, the properties of the model at the beginning are preserved in long run equilibrium, the original equilibrium was stable. As a consequence, aggregate demand y d can temporarily deviate from its full-employment level.


Table 1 lists the top-ranked international economics Ph. The idea has enormous appeal, but took some time to penetrate the economics profession, not least because few economists were familiar with the now standard techniques needed to implement it. One often sees this pattern in practice, particularly for countries pdice are forced dornbuech quickly reverse current account balances.

Regardless, of course, Dornbusch’s model was an important precursor to today’s exchange rate literature.

Overshooting model – Wikipedia

Undershooting I have mosel mentioned that overshooting does not have to happen in this model, depending on the parameters. The general reaction of policy economists at the time was mocel these alternative models, while elegant, were far less relevant empirically than Dornbusch’s variant. Shicky this is certainly not the case with the “overshooting” result, as I will now briefly illustrate.

It is only now, having just arrived as Economic Counsellor at the International Monetary Fund, that I have come to appreciate the wisdom of the standard convention. Instead, they were an order of magnitude more volatile, far more volatile than most experts had guessed they would be. At the same time, however, they can be viewed as direct descendants. Now, of course, unless one is steeped in recent economic theory, little of what appears in today’s professional economics journals will seem obvious.