Lecture 7

Dornbusch Model

Dornbusch model is a an hybrid: short-run features as the Mundell-Fleming model and long-run features as in the Monetary Model. Sticky price model: prices are xed in the short run and they adjust slowly towards the long run equilibrium. Main features: dichotomy between speed of adjustment in goods (slow) and nancial markets (instantaneous).

note that in what follows variables are expressed in logarithms Building blocks of our small open economy; (we take r and P as given) Aggregate Demand Block: (IS-LM mechanism in open economy) Output demand: y d = h(e + p p)
+

where q = e + p p represents the real exchange rate. Demand for money: m p = ky lr

Aggregate Supply Block: (goods prices are sticky) The aggregate supply curve is horizontal in the immediate impact phase, increasingly steep in the adjustment phase and vertical in the long-run. p =

yd

where p = pt pt1 and y is the level of long-run output (full-employment level). UIP condition always holds: r = r + ee Exchange rate expectations mechanism: ee = (e e) with > 0 So we can substitute to have our nal UIP equation: r = r + (e e)

Description of long run equilibrium: 1) Aggregate demand is equal to aggregate supply ) no upward or downward pressure on price level. 2) Domestic and foreign interest rates are equal ) the exchange rate does not change. 3) The real exchange rate is at its long-run level at which there is no surplus or decit in the balance of payment. Consider monetary expansion in the Dornbusch model: First step is determining the long-run eect: 1) We know that aggregate demand has to be equal to y. So we know that long-run equilibrium will be on the vertical aggregate supply curve.

2) Since r hasn't change, we know that in the longrun equilibrium, r = r : our IS and LM curve need to go back at the original equilibrium. In particular the increase in money supply requires a proportional increase in the price level. 3) Since the IS curve depends only on the real exchange rate, this means that the real exchange rate has to return to the initial equilibrium. Impact eect: (keep in mind that goods market adjust slowly while nancial markets adjust istantaneously) a) Increase in Money supply determines a decrease in the domestic interest rates (liquidity eect) in order to accommodate the excess supply of real money balances (the excess supply arises because of sticky prices). b) Uncovered interest parity implies that the fall in the domestic interest rate is compatible only if there is

an equilibrating change in the nominal exchange rate. In order to keep domestic assets in their portfolio, households should expect the nominal exchange rate to appreciate along the path that goes to the long-run equilibrium c) In order to generate expectation of appreciation, the nominal exchange rate overdepreciate (overshooting), so that the domestic currency is so undervalued that it is expected to appreciate in the future. d) Given the depreciation of the nominal exchange rate the IS curve shift outward. Overshooting depends on: -the interest sensitivity of the demand for money. The smaller it is the steeper is the LM curve and the greater the fall in the interest rate resulting from an increase in real money stock;

-the sensitivity of market expectations to deviations of the nominal exchange rate from the equilibrium value. The lower the sensitivity the higher is the required depreciation. Adjustment towards the long-run a) the excess demand for goods and services will tend to push up prices in the domestic economy. b) The increase in prices determines a decrease in the domestic competitive advantage. c) The increase in prices reduces real money balances. This will imply a backward shifting in the LM curve to its pre-disturbance level. In the process the real interest rate rises. d) Along the adjustment path the nominal exchange rate appreciates at a diminishing rate and IS curve is shifting back to its initial position (current account surplus is reduced).

Analytical analysis: We rst reduce our system: from the money demand equation m p = ky l [r + (e e)] and we can express it p = m ky + lr + l (e e) and from the good market equilibrium p = (h(e + p p) y) Now in equilibrium: aggregate demand is equal to the long run output d = y from which it follows that p = 0: level y

y ep = h Any change in the nominal exchange rate is matched by a corresponding change in the price level.

 expected changes in the nominal exchange rate is zero. p = m ky + lr Any change in the money supply is matched by a corresponding change in the price level Long run exchange rate: 1 e= k y + m + lr h a given percentage increase in the money stock implies a long run nominal depreciation and a long run increase in the price level in the same proportion;

a rise in full employment output ultimately results in a real exchange rate depreciation.

Graphical analysis: money market equilibrium (MM line)

p = m ky + lr + l (e e) = p l (e e)

goods market equilibrium (GM line) p = (h(e + p p) y) = h (q q) where q is the long run equilibrium level of the real exchange rate. The economy is always on the MM line which represent the short-run equilibrium and in the long run it is on the GM line that represents the goods market equilibrium.

 an increase in m determines a proportional increase in e and p such that q = e p does not change ) the GM does not move. an increase in m determines a shift in the MM curve outward to MM1. since the economy is always on the MM curve and prices are xed in the short-run, the exchange rate jumps to the level e2 consistent with the MM1: real and nominal exchange rate overshoots in response to monetary shocks and the economy reaches point C

along the adjustment path the economy moves from C to B with the exchange rate appreciating and ination decelerating.

Dornbusch model: dynamic following a money supply increase.

GM

p = 0 e2 C

e1

e0

A MM1

MM0 p0 p