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Rudiger Dornbusch's model of exchange rate (1976) is a model of a world where in the face of perfect foresight, [nominal] exchange rates account for a greater variability than the fundamentals [i.e., inflation or money supply growth rates] (Bidian 3). According to Bidian, Dornbusch's "overshooting model" shows how unexpected monetary changes can produce an "overshoot" in the sense that the instantaneous exchange rate changes more than the long run exchange rate…
Bidian (3) notes the overshooting model will help us understand why: (i.) over the short run, there are deviations from purchasing power parity; (ii.) there is volatility in both the nominal exchange rate and in the real exchange rate. Using the money demand equation1, the UIP condition2 and the PPP condition3, the model uses [where yt is the national income, i* is the international interest rate (exogenous) and p* is the international price level (also exogenous)]:
The crucial ingredient is the assumption that prices pt is sticky in short run (Bidian 3). The following figure on the monthly variability of the US dollar/Deutsch mark exchange rate and the US/German price ratio illustrates this point:
Benigno (5-7) cites the following outcomes of monetary expansion in the Dornbusch model and the items must be noted in order to determine the long-run effect of the monetary expansion: 1) we know that aggregate demand has to be equal to the long run level of output given by y. ...
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