STICKY PRICES: DORNBUSCH MODEL

Hina Khalid

International Finance

Lecture 13

Housekeeping

Exam Quiz

Dynamic Sticky Price Monetary Model

The small country dynamic model has four key equations

Dynamic Sticky Price Monetary Model

Monetary Equilibrium (LM Curve).

M/P = L ( R, Y)

Goods Market Equilibrium (IS Curve). Y = Y( R, SP*/P, G, T) Q =SP*/P

Interest Rate Parity (Covered/Uncovered) R = R* + ∆S/S (expected)

•Phillips Curve ∆ P/P = F( Y – YL) YL: Long run Output

Dynamic Sticky Price Monetary Model

Need to distinguish between the long run and short-run equilibrium of the model.

Long-Run (Output at its long run and expected change in exchange rate is zero).

Short-Run (Goods Prices sticky)

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 deficit in the balance of payment.

Consider the effects of monetary policy under flexible and pegged exchange rates.

Dynamic Sticky Price Monetary Model

Monetary Policy under flexible exchange rates. Long run impact of a given, say, unanticipated 10 percent increase in M (via NDA).

Assert that effect is that S and P both rise by 10 percent in the long run and there is no impact on R or Y or P*. Long run Monetary Neutrality. (MV=PY)

Dynamic Sticky Price Monetary Model

Consider the short run and dynamic effect of the 10 percent (unanticipated) increase in M under flexible exchange rates.

Here we assume that there are rational expectations and that the expected exchange rate change depends on how far the current exchange rate is from its long-run equilibrium level.

Dynamic Sticky Price Monetary Model

See charts for the dynamic adjustment paths.

On impact, we get that the currency depreciates by MORE than the percentage increase in M of 10 percent and the long-run 10 percent depreciation .

Dynamic Sticky Price Monetary Model

This is known as short run exchange rate overshooting and it comes about because goods and services prices are sticky or slow to adjust.

In these circumstances, the exchange rate has to over adjust or overshoot on impact relative to its long run response.

Dynamic Sticky Price Monetary Model

What do the dynamics of the adjustment look like over time? Use diagrams with variables on the vertical axes and time on the horizontal. Shock at time T.

Exchange Rate: Currency initially over depreciates or overshoots and then appreciates gradually over time to be 10 percent depreciated relative to initial point in the long run.

S

Time

Time

Time

P

R

Unanticipated Monetary Expansion: Flex S

T

T

T

Y

Time

Time

Time

M

Q

Unanticipated Monetary Expansion: Flex S

T

T

T

Overshooting The exchange rate overshooting model

aims to explain why exchange rates have a high variance. The key insight of the model is that lags in some parts of the economy can induce compensating volatility in others.Dornbusch developed this model back when many economists held the view that ideal markets should reach equilibrium and stay there. Volatility, from this perspective, could only be a consequence of imperfect information or market obstacles.

Overshooting

Rejecting this view, Dornbusch argued that volatility is in fact a far more fundamental property than that.In simple terms, the model begins by observing that prices of goods are 'sticky' in the short run, while 'prices' in financial markets adjust to disturbances quickly.

Source: Wikipedia

Dynamic Sticky Price Monetary Model: Flex S

S P Y R Q S P Y R Q

M ++ 0 + - + + + 0 0 0

Monetary Expansion

Impact Effects Long-run Effects

Dynamic Sticky Price Monetary Model: Peg S

S P Y R Q S P Y R Q

M 0 0 0 0 0 0 0 0 0 0

Monetary Expansion

Effects are as expected. Change in NDA is immediatelyoffset 100 percent by NFA.

Impact Effect Long-Run Effect

Dynamic Sticky Price Monetary Model

What does the model tell us about fiscal policy under flexible and pegged exchange rates? Model is not really rich enough to say much that is interesting on fiscal policy.

Fiscal Policy under flexible and pegged exchange rates (No real dynamics). There are no long or short run effects on real output in this model.

Dynamic Sticky Price Monetary Model

Key difference between fiscal policy under pegged and flexible exchange rates is with regard to which variable brings about the required change in the real exchange rate.

Dynamic Sticky Price Monetary Model: Flexible Exchange Rate

S P Y R Q S P Y R Q

G - 0 0 0 - - 0 0 0 -

Fiscal Expansion

Impact Effect Long-Run Effect

Note that Fiscal Expansion causes nominal and real currency appreciation

Dynamic Sticky Price Monetary Model: Pegged Exchange Rate

S P Y R Q S P Y R Q

G 0 o + 0 0 0 + 0 0 -

Fiscal Expansion

Impact Effect Long-run Effect

Note that fiscal expansion causes real but NOT nominal currency appreciation

Dynamic Sticky Price Monetary Model

Questions on the dynamic sticky price monetary model?