Donrbusch Model

Question 1

What are the Dornbisch assumptions?

Answer 1

1. Domestic economy is open and small ( ie Ireland)
2. Economy begins from “standing start” ie Initialy static price (noinflation) static exchange rate, and BoP is in equilibrium
3. AD is determined by standard open economy IS-LM framework
4. Financial markets adjust instantenously and investors are risk neutral => UIRP holds
5. Perfect Capital mobility
6. Price level is sticky in the SR flat AS, increasingly steep in the adjustment phase and unltimately vertical AS in the LR equilibrium

Question 2

What is Dornbusch overshooting theory?

Answer 2

25% increase in money supply leads eventually to 25% rise in domestic prices and 25% fall in value of domestic currency(keeping relative competitiveness the same), but since domestic prices don’t change initially, the instantaneous effect is to cause domestic currency to fall by more than 25% (say 40%) giving temporary boost to domestic competitiveness of similar magnitude
As times passes after monetary expansion, excess demand for goods/ services pushes prices up (speed of this depends on scale of initial disequilibrium and speed at which product-and labour-markets respond)
AS curves get progressively steeper
As prices rise, excess demand is eliminated

Question 3

What is the extent of overshoot depends on?

Answer 3

• Interest sensitivity of demand for money (denoted by l in Md/P =ky-lr) – the smaller l is, the steeper the LM curve => the greater the fall in interest rate resulting from a given increase in money stock
• Slope of RP line-the flatter the RP line, the more the exchange rate needs to overshoots l-r equilibrium for a given change in interest rate (since slope of RP line is –Θ, the more sluggish market anticipations are the greater the overshoot)