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 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.

One can find the idea of exchange rate overshooting peice invoked in the pages of the financial press and in the speeches of major policy leaders. Samuelson’s discussion is largely abstract, but he demonstrates general conditions under which, if some variables adjust slowly, others may initially over-react. This divergence of views led to a long rift between macroeconomics and much of mainstream international finance. It is only now, having just arrived as Economic Counsellor at the International Priec Fund, that I have come to appreciate the wisdom of the standard convention.

Overshooting model

Stanley Black had already introduced rational expectations to international macroeconomics. Even today, the model in its original form remains relevant dornvusch policy analysis. Also, the somewhat ad hoc Kouri and Calvo-Rodriguez models came along just as the more elegant intertemporal approach to the dornvusch account was being developed by many scholars but not least including Obstfeld, Sachs and Calvo himselfso they were also quickly dated from a theoretical perspective, as well.

Sitting beside dorrnbusch MIT students, there were also many Ph. The broad concept of overshooting has taken on a life stifky beyond the academic sphere.

The overshooting modelor the exchange rate overshooting hypothesisfirst developed by economist Rudi Dornbuschis a theoretical explanation for high levels of exchange rate volatility. Before proceeding to more analytic material, it is perhaps helpful to say a bit about how this author first learned the Dornbusch model. My class sitcky to include the brilliant and charming Eliana Cardoso, whom Dornbusch later married. Last, but not least, a complete formulation of the model is necessary for empirical implementation.

Second, Dornbusch was the first paper in international finance to marry sticky prices with rational expectations, both central features of today’s mainstream “post” Mundell-Fleming-Dornbusch model. He was a firm believer in the flexible-price Lucas islands model, and spent much of the meal ranting and raving about the inadequacies of the Dornbusch model: The second part of the lecture is a more detached discussion of the empirical evidence for and against the model, and a thumbnail sketch of the model itself.


Paul Samuelson once remarked that there are very few ideas in economics that are both a true and bnot obvious. To make things even more challenging, his class typically meets very early in the morning, far earlier than the sticly graduate student is accustomed to rising.

I have already mentioned that overshooting does not have to happen in this model, stickyy on the parameters. Contrary to Friedman’s rosy depiction of life under floating, exchange rate changes did not turn out to smoothly mirror international inflation differentials.

This, too, is influence.

These include, not least, how to allow for more general types of monetary disturbances, for the endogeneity of the money dornbisch and interest rates, for real shocks, etc. This initial excess depreciation leaves room for the ensuing appreciation needed to simultaneously clear the bond and money markets. This is, of course, the convention in the theory of international finance, and it is one I have always felt awkward about passing on to my own students at Harvard and Princeton.

Fischer, Stanley,”Long-term contracts, rational expectations, and the optimal money supply rule; Journal of Political EconomyVol.

The first, equation 1 below, is the “uncovered interest parity” condition. But if it is not at this intersection, then it must lie on the line marked by arrows, as any other starting point will lead down a path in which the exchange rate either explodes or collapses, even if the money supply remains constant.

The Overshooting Model in Perspective One of the first words that comes to mind in describing Dornbusch’s overshooting paper is ” elegant “. Dornbusch considered mosel case to be quite unrealistic prlce most evidence suggests that monetary policy significantly affects output only pricf a lag. The modeo of rational expectations made the model far more intriguing.

Figures 7a-dshow the correlation of real exchange rate and current account imbalances in Thailand, Korea, Indonesia and Mexico in the s. Dornbusch’s classes during the three years included many MIT students who went on to become luminaries in the field. That is, if home and foreign bonds are perfect substitutes, and international capital is fully mobile, the two bonds can only pay different interest rates if agents expect there will be compensating movement in the exchange rate.


Woodford, Michael, and Julio J. However, this effect turns out to be of secondary importance in this context. There modeo more than a few of us in my generation of international economists who still bear the scars of not being able to publish sticky-price papers during the years of new neoclassical repression. One has to realize that dornbusfh the time Dornbusch was writing, the world had just made the transition from fixed to flexible exchange rates, and no one really understood what was going on.

That is, aggregate supply is horizontal in the short run, though it is positively sloped in the long run.

Overshooting model – Wikipedia

Movements in the three series are almost indistinguishable. For a more formal derivation, I will leave it for the reader to look at Dornbusch or the exposition in Chapter 9 in my book with Obstfeld, since it is not essential to our discussion here.

pprice Is there anything that was not already obvious by looking at equations 1 and 2? As one can see, the exchange rate must overshoot its long-run equilibrium. The “overshooting” paper-as everyone calls it-marks the birth of modern international macroeconomics.

Of course, today, the mocel has swung back entirely, and there is a broad consensus across schools of thought that some form of price rigidity is absolutely necessary to explain real-world data, in either closed or open economies.

At the time Rudi was working on his paper, the concept of sticky prices was under severe attack. Rudi has what can only be described as a confrontational style of teaching, challenging his class with a mix of incredibly cornbusch questions. And remember, these figures only includes journal articles, not books and conferences. Now, of course, unless one is steeped in recent economic theory, little of what appears in today’s professional economics journals will seem obvious.

This will also give the reader a bit of the flavor of the period. Dornbusfh relationships lie at the heart of the overshooting result.