Dornbush model of sticky prices Flashcards
Explain the similarities between The Dornbusch sticky- price model and the Fleming Mundell model.
(5 points)
- LR: ΔM=ΔP=ΔS
- SR: Prices are sticky and don’t change
- Excess money supply: Lower interest rate domestically than in the rest of the world
2 effects on S:
• a)ΔM: corresponds to long- run change in S
- b)Δr: as r drops, capital flows out and S depreciates in the short run (IS-LM)
- IS-LM model is implied in this part of the Dornbusch model
- Consequence: Overshooting:
- exchange rate depreciates more than
- ΔM=ΔP=ΔS
Explain the difference between the Dornbusch sticky price model and the monetarist flexible price model
(5 points)
- PPP does not always hold (as the flexible price monetarist model assumes)
- Sticky Price model: goods and labour markets adapt slowly in response to shocks such as changes in money supply.
- PPP holds only on the long run, however foreign exchange markets adapt quickly:
- Exchange rates appreciate and depreciate in response to shocks
- Consequence: price movements don’t match PPP
left/right of gg
left excess supply of goods, so prices drops
right excess demand of goods, so prices rise
why GG slopes up less than unity
ER to price
• GG is upwards sloping from left to right with
slope less than unity:
• A depreciation of the exchange rate:
• Increased demand for exports offset by increase
in domestic price level
• Rise in prices: increase in money demand
• Rise in r that further reduces demand
• Percentage depreciation of the exchange rate
has to be higher than percentage increase in the
price level to keep aggregate supply in line with
aggregate demand.
why MM slopes down
price to ER
• MM: negative slope:
• Fall in price level given a money stock implies a
high money stock
• High money balances will only willingly be held if
domestic interest rate drops
• Fall in interest rate requires an expected
appreciation of the currency
• Exchange rate expectations are regressive:
expected appreciation only if exchange rate
depreciates
