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Dornbusch Overshooting Model Explained

This document provides an overview of the Dornbusch overshooting model from 1976. The model relies on two key equations: 1) uncovered interest parity and 2) a money demand equation. It describes how in the short-run, following an unexpected increase in the money supply, the exchange rate will overshoot and rise above its long-run level before gradually falling back. This occurs as capital flows out of the country, pushing the exchange rate down until expected future price increases and interest rate adjustments induce the currency to appreciate over time. For overshooting to occur, the model assumes prices adjust slowly to demand and demand is not highly sensitive to price changes.

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Hector Perez Saiz
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476 views3 pages

Dornbusch Overshooting Model Explained

This document provides an overview of the Dornbusch overshooting model from 1976. The model relies on two key equations: 1) uncovered interest parity and 2) a money demand equation. It describes how in the short-run, following an unexpected increase in the money supply, the exchange rate will overshoot and rise above its long-run level before gradually falling back. This occurs as capital flows out of the country, pushing the exchange rate down until expected future price increases and interest rate adjustments induce the currency to appreciate over time. For overshooting to occur, the model assumes prices adjust slowly to demand and demand is not highly sensitive to price changes.

Uploaded by

Hector Perez Saiz
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd

Lecture 14:

Historical Landmarks

Instructor: Thomas Chaney


Econ 357 - International Trade (Ph.D.)

intro

1 Dornbusch overshooting model (1976)


The Dornbusch overshooting model relies mainly on two equations: the
uncovered interest parity, and a money demand equation,
it+1 i = Et [et+1 et ]
mt pt = it+1 + yt
The uncovered interest parity states that the if bonds at home and
abroad are perfect substitutes, and if there is perfect mobility of capital,
then the only way the nominal interest rate at home can be lower than
interest rates abroad (i below i ) is if investors expect the domestic
currency to appreciate. This way, investors who invest domestically
are compensated for the lower interest rate by an appreciation of the
domestic currency (et+1 below et ).
The second equation is a classical money demand equation. The real
money demand depends negatively on the domestic interest rate (which
is the opportunity cost of holding money), and positively on total output
(which drives up the demand for money to perform transactions).
We need a few more assumptions:
1. Prices are sticky, so that they don’t adjust instantanuously to un-
expected monetary disturbances.
2. Output is taken as exogenous, since we consider a short term view
of the economy.
3. Money is neutral in the long run, so that in the long run, prices and
nominal exchange rates will move one for one with disturbances in
the supply of money.

1
Consider an unexpected increase in the money supply. In the long
run, prices and the nominal exchange rate will increase proportionately,
so that the increase in money supply is washed out by in‡ation and a
corresponding depreciation of the exchange rate.
In the short run however, prices cannot directly adjust to their long
term level. So the real money balances in the economy have to rise in
the short run. To equilibrate the money market, since output is …xed,
the domestic nominal interest rate must fall.
But we know from the uncovered interest parity that the only way
domestic interest rate may fall is investors expect the exchange rate to
appreciate in the future. How can the exchange rate appreciate, when
we know that in order to reach a new steady state, the exchange rate
has to depreciate? The answer is, overshooting: in the short run, the
exchange rate will jump above its long run level, and then gradually fall
back towards its long run level.
What is happening behind the scenes is that following the monetary
expansion, the domestic interest rate falls below the foreign interest rate.
This induces a massive ‡ight of capital abroad. The exit of capital will
push down the domestic exchange rate, so that the domestic currency
depreciates. The out‡ow of capital stops when the exchange rate reaches
a point such that the expected future rise in domestic prices, and hence
the gradual increase in the domestic interest rate back to its steady state
level, which will be accompanied by an appreciation of the exchange rate,
and hence a gradual appreciation of the exchange rate.

it+1 i = Et [et+1 et ]

mt pt = it+1 + yt

ytd = y + (et + p pt e)
with > 0. Demand depends on the di¤erence between domestic and
foreign prices.

pt+1 pt = ytd y + et+1 et


so that if there is excess demand for domestic goods, domestic prices
have to increase and/or the exchange rate has to appreciate.

q e+p p
the real exchange rate. If we normalize p = 0, we can rewrite the price
adjustment equation as,
qt = (qt q)

2
Combining the uncovered interest rate parity equation and the money
demand equation, we get,

mt et + qt = (et+1 et ) + (qt q)

In order to get overshooting, we need the assumption < 1. That


will happen as long as small (demand is not too sensitive to prices),
and small (prices don’t adjust too quickly to excess demand).

q=0 q=q
,
e=0 e=m+ q + (1 )q

2 Salant and Henderson (1978)

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