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Dornbusch Exchange Rate Overshooting Model

Info: 3225 words (13 pages) Essay
Published: 19th Oct 2021 in Finance

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The purpose of this essay is to look an also analyse if the Dornbusch exchange rate overshooting model. This will involve looking at analysis of the model and whether this model is still applicable today including assessing the weaknesses of this model. This will be achieved by looking at articles and texts written on this model and then I will intend to conclude my views on whether this model is still suitable in todays markets and if this model works.

A brief introduction to the overshooting model and why it came about. The model was introduced by Rudiger Dornbusch in 1976. The previous model used was the Bretton Woods model. The Dornbusch model which according to (Rogoff 2002) is viewed as a classic piece of work in the economic world and is viewed as the birthplace of macroeconomics.

The Dornbusch model was introduced when the finance and economic world was changing from the Bretton Woods agreement from 1994 when at the end of world war two the forty-four allied nations met in Bretton Woods New Hampshire in the United States of America. (Pickford 2019)

The main parts of this agreement were that countries via their central banks would maintain fixed exchange rates to the US dollar. This agreement worked in two ways. If a countries currency became too low against the US dollar then that countries central bank would buy the US Dollar so to its lower supply of the currency resulting in an increase of its price. The other way this agreement worked was if the countries currency became too high against the US Dollar then that countries central bank would print more money resulting in an increase of supply of that countries currency and lowering the price of that currency. (Amadeo 2019)

Pickford 2019 also states that due to the changes in the structure of global economics that in the 1970s the IMF moved away from fixed exchange rates to floating exchange rates. This in turn prompted Dornbusch to look at this and in 1976 came up with his model which is still used today.

Dornbusch Overshooting Model

The Dornbusch overshooting model was written by Rudiger Dornbusch in 1976 in a paper titled “Expectations and Exchange Rate Dynamics” which according to (Hale 2019) is the most citied professional article in the international world of economics.

Copeland 2005 goes on to further describe the outline of the model as a hybrid. He further states that “In its short-run features, it fits into the established Keynesian tradition, with its emphasis on the stickiness of prices in product (and labour) markets.” He finishes off his outline by stating that this model concurrently displays the long-term characteristics of the monetary model.

Copeland 2005 goes on to state that the fallout from all this means that the financial markets must overcompensate these disturbances so to atone for the stickiness of prices within the goods market.

The hypothesis by Dornbusch focuses on markets. It looks at product markets which only adjust slowly compared to the financial markets which adjust much quicker or in some cases can adjust almost instantly. This is further backed up by Dornbusch 1976 in the Journal “Expectations and Exchange Rate Dynamics” which he states that the dynamics of the exchange rate determination of the model appear in anticipation of the exchange rates and the asset markets alter quicker if not instantaneously due to the corresponding goods market.

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According to (Pilbeam 2013) the Dornbusch model is described as they sticky-price monetarist model which introduced a concept called exchange rate overshooting. He goes on further to explain the foundations of the model is that prices within the goods markets and wages from within the labour market are determined in sticky-price markets which over a period change slowly in response to any changes in the supply of money. Compared to the exchange rate market which is determined by a flex-price market which can either appreciate or depreciate due to any kind of response from new improvements or shocks.

According to (Breaking Down Finance, ND) the Dornbusch overshooting model can be held under various assumptions. A key assumption according to them is that the prices within the goods market are referred to as sticky-prices which is seen as a key assumption. Other assumptions according to Breaking Down Finance are that the model focuses on a small open economy. Another assumption made is that the exchange rates are flexible and there is no capital controls or fixed exchange rates.

Breaking Down Finance goes further with an overview of the Dornbusch overshooting model by saying that when there is a change in monetary policy for example a change to the interest rate decreasing then the markets must adjust for this giving a new equilibrium. Although, with the sticky-prices then a new short run equilibrium which the financial markets would reach first. It is worth mentioning though that because the goods and labour market respond slower to changes that the new equilibrium would be based upon the old prices of goods instead of the new prices caused by the change in the market conditions. Therefore, the goods and labour market are referred to as sticky-prices. As the goods market adjusts for the changes this will lead to a new change in the exchange rates once more. This causes the exchange rates to overshoot due to being based upon the old prices initially.

With the goods market adjusting to the changes in the market so too will the exchange rate market adjust. This is seen as a long-term equilibrium which is caused by the time it takes for the goods market to catch up with the exchange rate market. This causes other issues in the markets. Due to the exchange rate market adjusting too quickly and needing to change quickly so for equilibrium in the markets causing exchange rate volatility initially.

Another implication as discussed by (Breaking Down Finance ND) is a change in the interest rate. A currency can appreciate even if that countries interest rate has lowered. This is because an event in relation to the currency has already occurred. That event being that the currency has already depreciated.

Strengths and Weaknesses of the Dornbusch Overshooting Model

This section will look at any strengths and weaknesses of the model which were discovered in the writing of the papers used by myself for analytical evidence of the model. I will do so by providing evidence found in research carried out by others who have written papers previously. Firstly, I will look at the strengths of the model found in research.

According to (Tu et al., 2009) there are three points highlighted as strengths from their research on the Dornbusch overshooting model. The first point that they highlight in their work is that with the inescapable amount of newer more modern approaches to this work, the Dornbusch Overshooting model is still central to any analysis of policies related to the exchange rate and monetary policies made by central banks and governments today.  They go further to say that the sticky prices within the goods and labour markets along with the exchange rate unpredictability there is a requirement for a temporary equilibrium within the economy in response to changes in monetary policies.

Another point raised by (Tu et al., 2009) is that the paper written by Dornbusch “Expectations and Exchange Rate Dynamics” became the very first paper within the international economic world that successfully associated sticky-prices with analytical expectations which today are both seen as fundamental features. The fundamental expectations signify that independent private agents must form exchange rate predictions to a way that is consistent with the model itself (Rogoff, 2002). Put another way, this paper combined the Keynesian short-term analysis along with the Monetarism long-term analysis so to find a more appropriate reality and equilibrium.

One final point raised by (Tu et al., 2009) is that the model is central to the analysing of an open economy within the international macroeconomic world. This is because the model specifically the intellectual simplicity as well as elegant and the clarity of the model. In fact (Rogoff, 2002) goes on to state that if anyone needed to question monetary policy may affect the exchange rate then they would look to this model so to check their answer.

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Like everything else there are weaknesses that have been discovered in the model during research. According to research carried out by (Tu et al., 2009) the Dornbusch Overshooting model is at the forefront of analysis of policy making for the past thirty years although during this time the model itself has been under scrutiny since the model was published for the first time in 1976. (Tu et al., 2009) goes on further to say that after various analytical interpretations of overshooting that in fact undershooting can also occur under certain circumstances.

From factual data (Rogoff, 2002) shows that an underlying problem with the model is that where it seems to highlight considerable points in monetary policy, the model itself does not capture other significant swings in the exchange rate that take place on a regular basis. (Rogoff, 2002) goes on further to say correctly testing the Dornbusch Model is easier said than done.

Another point that (Tu et al., 2009) raises is that the Dornbusch Overshooting model is that evidence from shifts from both the forward rate and the spot rate of exchange. The thought of the model by Dornbusch is that unforeseen movements in money supply should see the spot rate should move by more than the forward rate.

As illustrated by (Flood, 1981) in most cases the overshooting model will predict that spot or forward rates will not move on a one for one basis. (Flood, 1981) goes on further to say that specific movements of the spot and forward rates will be based on the type of shock for example (nominal verses real, permanent verses temporary) as well as the extent of the forward rate.

Other limitations of the Dornbusch model according to (Da Silva, 2000) is that the model presented drawbacks which highlighted the lack of micro foundations. They go on to explain further that the model itself provided specifics of the price determination processes but avoided the current account within the exchange rate process (Isard, 1995). This goes further to state that the model also neglects the indeterminable budget constraints that describe the current account and also the fiscal policy persistently as the model does not describe in anyway how the monetary policy goes on to affect decisions related to production nor does it show any important welfare foundations, which in turn could lead to ambiguous policy decisions (Obstfeld and Rogoff, 1995)

Relevance today

Looking at all the evidence so far and the changes that we have seen over the last thirty years you would think that the Dornbusch Overshooting Model would be irrelevant nowadays. Well in a lecture at the International Monetary Fund (IMF) there is evidence to say that this is in fact false. The total opposite in fact. This written thirty years ago is still as relevant now as it was back in 1976 when it was written.

The lecture goes on to say that although there have been various models made that are like the Dornbusch model although these newer models have more exacting micro-foundations in consumer as well as investor behaviours in comparison to the Dornbusch model itself. In fact, the speaker at the lecture (Rogoff, 2001) goes on to say that these newer models can be viewed as descendants of the Dornbusch model.

Rogoff (2001) in the lecture titled “Dornbusch’s Overshooting Model after twenty five years, The Mundell-Fleming lecture” By Kenneth Rogoff who at that time was the Economic Councillor and Director of the IMF Research Department goes on to say that even with onset of more modern approaches to the model that the Dornbusch model today is still relevant on its own, this is due to the accurate and comprehensible, easy to understand and elegance of the model itself.

He goes on further to state that if someone needed answering a question related to monetary policy changes affecting the exchange rate then this would be the model to refer to for an answer to the situation.

Rogoff (2001) also states that the true strength of the model itself is how it highlights todays modern economies that thought must be given to co-operation between slow moving goods markets and the overactive asset markets. According to Rogoff (2001) this gives us an extensive observation which positively still lies at the core of the present-day thinking regarding exchange rates, although the details of the other models may differ compared to the Dornbusch Overshooting Model.

During the lecture he goes on to inform everybody that the model still gets citied even today. He goes onto explain the Dornbusch Overshooting Model has since been citied in excess of 900 times from 1976 to 2001. He goes on to compare this with an example stating that during the lifetime of a typical middle-aged American who attend a top five American university would have around 500 citations in a lifetime which is considered to be not bad for one of their all of their articles but for Dornbusch who has had over 900 citations for just one paper gives you an idea of the scale that this paper has been used since it was published.

The peak period for the article in question was the period between 1984-1986, during this period the article had received in excess of 50 citations annually. When you consider that the article itself was only written ten years prior it shows how important the article was then. But when you go into the 1990s the article is still relevant and still viewed as important to scholars and economists alike. Even towards the end of the 90s decade the article itself was still receiving in excess of 25 citations per year. Considering these figures are only for Journals and not including being referred to in conferences or even in books this proves that the Dornbusch Overshooting Model is still held as the most important paper even today.

According to (Rogoff, 2001) during his lecture he informed his audience that an informal survey was carried out on international finance reading lists at the leading universities. The results of the survey found out that the Dornbusch article was the only single article to be included on over half of the reading lists. Plus, today with the internet and a lot of these articles and papers made available online it is not of any surprise to note that in the international finance courses available that the Dornbusch article is practically on the reading list of every course. This evidence goes to show that even today the Dornbusch overshooting model is still relevant and very important in the teachings of economics and used in policy making decisions.

In addition to being published for academic learning the Dornbusch Overshooting Model according to (Rogoff, 2001) has also been mentioned within media circles as well when reporting on monetary matters as well as monetary and economic policy. A prime example of this is that in years 1999-2000 a magazine called the economist had published fourteen articles all either containing the terms “overshooting” and “exchange rates”. Furthermore, the financial times newspaper had eleven references to the Dornbusch Overshooting Model.

Also, in recent months to this lecture taking place it is also noted that both the Federal Reserve and the Bank of France had referred to overshooting in speeches at conferences. The people in question for these speeches are Chairman of the Federal Reserve Alan Greenspan and the president of the Bank of France Claude Trichet both (2001) discussed overshooting in the speeches at their respective conferences and based on this evidence there is no doubt that countless other speeches, articles, papers and journals will have mentioned or referenced the Dornbusch Overshooting Model just like the paper itself will no doubt still be included in the reading lists of universities around the world for business and economic students alike.

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