Lecture 7

Dornbusch Model
Dornbusch model is a an hybrid: short-run features as
the Mundell-Fleming model and long-run features as
in the Monetary Model.

Sticky price model: prices are ¯xed in the short run

and they adjust slowly towards the long run equilib-
rium.

Main features: dichotomy between speed of adjust-

ment in goods (slow) and ¯nancial markets (instanta-
neous).
note that in what follows variables are expressed in
logarithms

Building blocks of our small open economy;

(we take r ¤ and P ¤ as given)

Aggregate Demand Block: (IS-LM mechanism in open

economy)

Output demand:

y d = h(e + p¤ ¡ p)
+
where q = e + p¤ ¡ p represents the real exchange
rate.

Demand for money:

m ¡ p = ky ¡ lr
Aggregate Supply Block: (goods prices are sticky)

The aggregate supply curve is horizontal in the imme-

diate impact phase, increasingly steep in the adjust-
ment phase and vertical in the long-run.
³ ´
¢p = ¼ yd ¡y

where ¢p = pt ¡ pt¡1 and y is the level of long-run

output (full-employment level).

UIP condition always holds:

r = r ¤ + ¢ee
Exchange rate expectations mechanism:

¢ee = µ (e ¡ e) with µ > 0

So we can substitute to have our ¯nal UIP equation:

r = r¤ + µ (e ¡ e)
Description of long run equilibrium:

1) Aggregate demand is equal to aggregate supply )

no upward or downward pressure on price level.

2) Domestic and foreign interest rates are equal )

the exchange rate does not change.

3) The real exchange rate is at its long-run level at

which there is no surplus or de¯cit in the balance of
payment.

Consider monetary expansion in the Dornbusch model:

First step is determining the long-run e®ect:

1) We know that aggregate demand has to be equal

to y. So we know that long-run equilibrium will be on
the vertical aggregate supply curve.
2) Since r¤ hasn't change, we know that in the long-
run equilibrium, r = r ¤: our IS and LM curve need
to go back at the original equilibrium. In particular
the increase in money supply requires a proportional
increase in the price level.

3) Since the IS curve depends only on the real ex-

change rate, this means that the real exchange rate
has to return to the initial equilibrium.

Impact e®ect: (keep in mind that goods market adjust

slowly while ¯nancial markets adjust istantaneously)

a) Increase in Money supply determines a decrease

in the domestic interest rates (liquidity e®ect) in or-
der to accommodate the excess supply of real money
balances (the excess supply arises because of sticky
prices).

b) Uncovered interest parity implies that the fall in

the domestic interest rate is compatible only if there is
an equilibrating change in the nominal exchange rate.
In order to keep domestic assets in their portfolio,
households should expect the nominal exchange rate
to appreciate along the path that goes to the long-run
equilibrium

c) In order to generate expectation of appreciation,

the nominal exchange rate overdepreciate (overshoot-
ing), so that the domestic currency is so undervalued
that it is expected to appreciate in the future.

d) Given the depreciation of the nominal exchange

rate the IS curve shift outward.

Overshooting depends on:

-the interest sensitivity of the demand for money. The

smaller it is the steeper is the LM curve and the
greater the fall in the interest rate resulting from an
increase in real money stock;
-the sensitivity of market expectations to deviations of
the nominal exchange rate from the equilibrium value.
The lower the sensitivity the higher is the required
depreciation.

Adjustment towards the long-run

a) the excess demand for goods and services will tend

to push up prices in the domestic economy.

b) The increase in prices determines a decrease in the

domestic competitive advantage.

c) The increase in prices reduces real money balances.

This will imply a backward shifting in the LM curve
to its pre-disturbance level. In the process the real
interest rate rises.

d) Along the adjustment path the nominal exchange

rate appreciates at a diminishing rate and IS curve is
shifting back to its initial position (current account
surplus is reduced).
Analytical analysis:

We ¯rst reduce our system: from the money demand

equation

m ¡ p = ky ¡ l [r¤ + µ (e ¡ e)]

and we can express it

p = m ¡ ky + lr ¤ + lµ (e ¡ e)
and from the good market equilibrium

¢p = ¼ (h(e + p¤ ¡ p) ¡ y)
Now in equilibrium:

² aggregate
³ demand
´ is equal to the long run output
level y d = y from which it follows that ¢p = 0:
y
e¡p =
h
Any change in the nominal exchange rate is matched
by a corresponding change in the price level.
² expected changes in the nominal exchange rate is
zero.
p = m ¡ ky + lr ¤
Any change in the money supply is matched by a
corresponding change in the price level

Long run exchange rate:

µ ¶
1
e= ¡ k y + m + lr¤
h

² a given percentage increase in the money stock

implies a long run nominal depreciation and a
long run increase in the price level in the same
proportion;

² a rise in full employment output ultimately results

in a real exchange rate depreciation.
Graphical analysis:

money market equilibrium (MM line)

p = m ¡ ky + lr ¤ + lµ (e ¡ e)
= p ¡ lµ (e ¡ e)

goods market equilibrium (GM line)

¢p = ¼ (h(e + p¤ ¡ p) ¡ y)
= ¼h (q ¡ q)
where q is the long run equilibrium level of the real
exchange rate.

The economy is always on the MM line which repre-

sent the short-run equilibrium and in the long run it
is on the GM line that represents the goods market
equilibrium.
² an increase in m determines a proportional in-
crease in e and p such that q = e ¡ p does not
change ) the GM does not move.

² an increase in m determines a shift in the MM

curve outward to MM1.

² since the economy is always on the MM curve and

prices are ¯xed in the short-run, the exchange rate
jumps to the level e2 consistent with the MM1:

² real and nominal exchange rate overshoots in re-

sponse to monetary shocks and the economy reaches
point C

² along the adjustment path the economy moves

from C to B with the exchange rate appreciating
and in°ation decelerating.
Dornbusch model: dynamic following a money supply increase.

e GM

∆p = 0

e2 C

e1
B

e0 A

MM1

MM0

p0 p