____________________________________________________________________________________________________

Subject ECONOMICS

Paper No and Title 6: Advance Macroeconomics

Module No and Title 7: Dornbusch’s Exchange Rate Overshooting Model

Module Tag ECO_P6_M7

ECONOMICS Paper 6: Advanced Macroeconomics

Module 7: Dornbusch's Exchange Rate Overshooting Model
____________________________________________________________________________________________________

TABLE OF CONTENTS

1. Learning Outcomes
2. Introduction
3. Basic Assumptions of Dornbusch Overshooting Model
4. Mathematical Derivation of Dornbusch Overshooting Model
5. Graphical Representation of Dornbusch Overshooting Model
6. Monetary Policy Change and Dornbusch Overshooting Model
7. Summary

ECONOMICS Paper 6: Advanced Macroeconomics

Module 7: Dornbusch's Exchange Rate Overshooting Model
____________________________________________________________________________________________________

1. Learning Outcomes

After studying this module, you shall be able to

 Know the concept of Dornbusch Overshooting Model
 Mathematically derive the model
 Understand its implications for a small open economy in the short-run
 Learn how to depict the model graphically.
 Identify the effects of a change in monetary policy on the exchange rates.

2. Introduction
Some economists hold the view that volatility in the exchange rate market is a result of
speculators, information asymmetries, and market imperfections. However, it was in the
year 1976 when the economist Rudiger Dornbusch published his paper titled,
“Expectations and Exchange Rate Dynamics”, in the Journal of Political Economy that
gave the birth toa new international macroeconomic theory to explain the dynamics of the
exchange rates, while at the same time, providing reasons to why such volatility in
exchange rates is consistent when everyone in the economy follow rational expectations
for the exchange rates. This model is now widely known as “Dornbusch Overshooting
Model”. According to this model, in the short-run, due to the assumption of sticky prices,
when there is a change in monetary policy, there is an extreme volatility nominal
exchange rate going well beyond their long-run level. This extreme volatility is explained
by the term “overshooting” in Dornbusch Overshooting Model. Sometimes, this model is
also considered as dynamic version of Mundell-Fleming Model. This model is a mixture
of sticky prices assumption of the short-run Mundell-Fleming Model, and flexible
exchange rates, and rational expectations from the long–run models, in which prices vary
in the long run. It is based on the observation that the adjustment in the foreign currency
market is very rapid, while the adjustment in the product market is sluggish.

In this module, we study the basic assumptions of this model, mathematical derivation of
this model, and how to represent the changes in monetary policy on exchange rates
graphically.

ECONOMICS Paper 6: Advanced Macroeconomics

Module 7: Dornbusch's Exchange Rate Overshooting Model
____________________________________________________________________________________________________

3. Basic Assumptions of Dornbusch Overshooting Model

Dornbusch Exchange Rate Overshooting Model is a model that assumes that the
economy is operating in the short-run, and it rests on some basic assumptions. These
assumptions are as follows:
(i) Small open economy: The country’s foreign capital market is small in
comparison to the world capital market, and hence, it faces a given interest
rate, which is equalized to the world interest rate.
(ii) Perfect capital mobility: There is perfect mobility of capital in and out of the
economy which ensures that the yield on the domestic securities is
equalized to the yield on the foreign securities. Thus, due to this
assumption, the uncovered interest parity condition holds, and assets
denominated in domestic currency and assets denominated in foreign
currency are considered as perfect substitutes.
(iii) Prices of imports are given: Since the economy is a small open economy, in
the domestic market, the world prices of imports are given. Domestic output
is a not a perfect substitute of imports. As a result, the prices of domestic
goods, (both absolute prices, and relative prices, in terms of imports) are
determined by the aggregate demand of domestic goods.
An implication of this assumption is related to the real exchange rates, which
are given by:
R=EP*/P
(1)
Where, E = nominal exchange rates
P* = Price of imports, which are given
P = Domestic price level
Taking the natural log on both the sides, we get:
Log R = LogE + Log P* - Log P
(2)
Since, P* is fixed, normalizing it to 1, we get, Log P* = Log 1 = 0. Thus, the
above equation becomes:
Log R = Log E- Log P
(3)
(iv) Output is given in the economy: The model assumes that the full
employment level of output or the natural output in the economy is given to
be some constant, say 𝑌̅. For simplicity, assuming 𝑌̅=1. So, in log terms,
Log𝑌̅=0. This normalization is done to make the analysis of the model
simpler.
(v) Sticky Prices and flexible exchange rates: The goods prices are sticky in the
short-run, but vary in the long run. This implies that aggregate supply is
horizontal in the short-run, but may be assumed to be vertical in the long
run. However, prices in the model are determined by the flexible exchange
ECONOMICS Paper 6: Advanced Macroeconomics
Module 7: Dornbusch's Exchange Rate Overshooting Model
____________________________________________________________________________________________________

rates regime. This assumption ensures that purchasing power parity

condition holds.
(vi) Both goods market and money market are in equilibrium.
(vii) All the variables are assumed to be in natural logarithmic terms, except the
rate of interest, and percentage change variables. This simplifies the
mathematical derivation of the model and the representation of the effect of
monetary policy change on the exchange rates.
(viii) Perfect Foresight: Agents in this model are assumed to have perfect
foresight when forecasting exchange rates. Perfect foresight is a special case
of Rational Expectations Hypothesis, also called Deterministic
Expectations. Thus, according to this equation the expected value of the
depreciation of the exchange rate will be equal to the actual depreciation of
the exchange rate. There is no random error component. In equation form, it
means: 𝐸(𝑒̇ ) = 𝑒̇
(ix) The economic agents are risk neutral.

4. Mathematical Derivation of Dornbusch Overshooting Model

Mathematical derivation of Dornbusch Overshooting Model requires equations
representing equilibrium in capital market, money market, and goods market. It also
requires the Phillips curve equation. These four equations represent the structure of
Dornbusch Overshooting Model. However, the full model requires two more equations
which represent simultaneous solutions to the above four equations. Thus, in all there are
six equations to this model. Let’s study them one by one.
(a) Capital Market
Due to the assumption of perfect capital mobility, and flexible exchange rates, interest
parity condition will always hold. This ensures that capital market will always be in
equilibrium. Thus, the equation for interest parity or capital market equilibrium is as
follows:
i = i* + E (𝑒̇ )
(4)
Where, i = domestic rate of interest
i* = World rate of interest
e = Domestic price of foreign currency or the exchange rate
𝑒̇ = Change in the domestic price of foreign currency or the depreciation of the exchange
rates.
Due to the assumption of perfect foresight, the above equation will become:

i = i* + 𝒆̇
(A)
(b) Money Market

ECONOMICS Paper 6: Advanced Macroeconomics

Module 7: Dornbusch's Exchange Rate Overshooting Model
____________________________________________________________________________________________________

Money market is assumed to be equilibrium, where money demand is equal to money

supply. Demand for real money balances is a function of domestic interest rates and real
income (Dornbusch, 1976). Nominal money supply is assumed to be fixed by the central
bank. Note that in the IS-LM framework, LM curve represents the money market
equilibrium. Thus, we have the following LM curve equation:
Real Money Supply = Real Money Demand
(5)
M/P = f(i,Y)
(6)
Where, M = Nominal Money supply
P = Domestic Price Level
Y = Real domestic output or income
Money demand is negatively related to domestic interest rates, and positively related to
real income. Assuming money demand takes a Cobb-Douglas functional form, we have:
𝑀
= 𝑌𝛽 𝑒 −𝛼𝑖
𝑃
(7)
Interest rate (i) enters in the exponential form.
Taking the above equation in natural log terms, we get:

m-p = -αi + βy
(B)
Where m = Log of nominal money supply
p = Log of price level
y = Log of output or income
α = Semi-Elasticity of money demand with respect to interest rate. Note that interest rate
is not in log terms.
β = Elasticity of money demand with respect to real income

(c) Goods Market

IS curve represents the goods market equilibrium. In the goods market, demand for
domestic goods depends on the relative price of domestic goods with respect to foreign
goods, interest rates, and real income (Dornbusch, 1976). Thus, we have the following
equation for IS curve:
Y = g (R, i)
(8)
Where R = Real exchange rate, or the relative price of domestic goods
As mentioned in equation (3) above, in natural log terms, we have
Log R = Log E - Log P
(3)
Or, we writing in simpler terms,
r=e–p
(9)
ECONOMICS Paper 6: Advanced Macroeconomics
Module 7: Dornbusch's Exchange Rate Overshooting Model
____________________________________________________________________________________________________

Giving functional form to the above IS curve equation, in natural log terms, and using
equation (9); we get the following equation for goods market equilibrium:

y = γ (e – p)
(C)
where γ is the functional form relating the responsive of demand for domestic goods to
relative prices. γ>0, implies that if exchange rates(that is the domestic currency)
depreciates, domestic goods become relatively cheaper in comparison to foreign goods,
and hence output (demand) will increase. The domestic currency depreciates, whenever
(e – p) increases.

(d) Phillips Curve

The fourth equation in the Dornbusch Overshooting Model is the Phillips Curve equation.
Phillips curve shows the inverse relationship between inflation and unemployment within
the economy. This curve can be molded to show positive relationship between inflation
and output. If output is above the full-employment level or the natural output, then there
is inflation in the economy. Thus, following is the Phillips curve equation in natural log
terms:
𝒑̇ = 𝝅(𝑳𝒐𝒈𝒀 − 𝑳𝒐𝒈𝒀 ̅)
(D)
Where, 𝑝̇ = Percentage change in the price level
Y = Output produced in the economy
𝑌̅= Full-employment level of output or Natural Output
𝜋 = Adjustment factor, gives the speed with which prices adjust to the difference in the
output level. Since prices increase with excess demand, and are sluggish or slow to
adjust, so 0 < π < ∞.
Thus, the above equation shows that the prices are proportional to the excess demand in
the goods market.

Structure of the Model

The structure of Dornbusch Overshooting Exchange Rate Model is given by the four
equations, (A), (B), (C), and (D), i.e.
i = i* + 𝒆̇ (A)
m-p = -αi + βy (B)

y = γ (e – p) (C)
̅)
𝒑̇ = 𝝅(𝑳𝒐𝒈𝒀 − 𝑳𝒐𝒈𝒀 (D)

Solution of the Model

Solving the above four equations for 𝑒̇ and 𝑝̇ , in terms of e and p, will give us two non-
homogenous equations. In equation (D), log 𝑌̅ = 0. We have assumed earlier that full-

ECONOMICS Paper 6: Advanced Macroeconomics

Module 7: Dornbusch's Exchange Rate Overshooting Model
____________________________________________________________________________________________________

employment output is given in the economy; it can be normalized to 1, to give us its log
value of zero. Thus, equation (D) simply becomes:
𝒑̇ = 𝝅𝒚
(D’)
Substituting value of y from equation (C) into the above equation, we get:

𝒑̇ = 𝝅𝜸(𝒆 − 𝒑)
(E)
Substituting value of y from equation (C) and value of i from equation (A) into equation
(B), we get the following equation of 𝑒̇ :
𝜷𝜸 𝟏 − 𝜷𝜸 𝟏
𝒆̇ = 𝒆+ 𝒑 − 𝒎 − 𝒊∗
𝜶 𝜶 𝜶
(F)
Equations (E) and (F) are the two non-homogeneous equations, which provide solution to
the Dornbusch Overshooting Model in terms of e and p. Solving these two equations
provides two roots, which are equal in magnitude, but opposite in signs. Positive root is
an unstable root, while negative root is a stable root. It is difficult to solve this equation
system of equation here, to get a steady state solution, as it requires matrix formulation.
Interested readers can refer to Heijdra and Ploeg (2002), and Dornbusch (1976).Hence a
graphical representation of the model is presented below to explain the implications of
the equations.

5. Graphical Representation of Dornbusch Overshooting Model

Graphically, Dornbusch Overshooting Model is represented through a Phase-Plane
Diagram. Phase-plane diagram shows steady state solution to the dynamic model. Price is
represented on the x-axis, and exchange rate on the y-axis. Along the two axis, equations
(E) and (F), showing the change in the variables (price (p), and the exchange rates (e)),
are plotted. To plot these two equation, they are equated to zero or 𝑒̇ = 0 and 𝑝̇ = 0.
Consider equation (F) first. We need to plot 𝑒̇ = 0 line. Nominal money supply (m) is
given by the central bank, and world interest rate (i*) is also given for an economy. These
two are shift parameters. Slope of this line is given by (de/dp), which is calculated as
follows:
𝑒̇ = 0
(10)
Or
𝛽𝛾 1 − 𝛽𝛾 1
𝑒+ 𝑝 − 𝑚 − 𝑖∗ = 0
𝛼 𝛼 𝛼
(11)
Taking Derivative:

ECONOMICS Paper 6: Advanced Macroeconomics

Module 7: Dornbusch's Exchange Rate Overshooting Model
____________________________________________________________________________________________________

𝛽𝛾 1 − 𝛽𝛾 1
𝑑𝑒 + 𝑑𝑝 − 𝑑𝑚 − 𝑑𝑖 ∗ = 0
𝛼 𝛼 𝛼
(12)
Since nominal money supply and world interest rates are given so, dm = 0 and di*=0. So,
we have:
𝛽𝛾 1 − 𝛽𝛾
𝑑𝑒 + 𝑑𝑝 = 0
𝛼 𝛼
(13)
Slope of 𝑒̇ = 0 is given by (de/dp), or from the above equation, we get:

𝒅𝒆 𝟏 − 𝜷𝜸
= −
𝒅𝒑 𝜷𝜸
(14)
Thus, if (1-βγ)>0, slope of 𝑒̇ = 0 line is negative, and it is downward sloping. If (1-
βγ)<0, slope of 𝑒̇ = 0 line is positive, and it is upward sloping.
Figure 1 below shows the 𝑒̇ = 0 line. Panel A shows upward sloping line, while Panel B
shows downward sloping line. Arrows drawn in the figure show how the system moves
along 𝑒̇ = 0 line. If the economy’s situationwere tobeabove this line, it means that for a
given price level, exchange rate would increase or that the domestic currency would
depreciate, making domestic goods cheaper in comparison to foreign goods. Demand and
hence output would increase. A higher output means a higher income, which would
trigger in a higher demand for money, creating disequilibrium in the money market.
Excess money demand over money supply would raise domestic interest rate relative to
the world interest rate or i>i*. To maintain interest parity condition and due to perfect
capital mobility, exchange rates would depreciate further, or ė > 0. Thus, at any point
above ė = 0 line, the system of economy will move up. Similarly, if the economy is at
any point below the 𝑒̇ = 0 line, it will move downwards. The arrows in the diagram show
the motion of the economy.

Figure 1: Movement of the economy along 𝑒̇ = 0 line

ECONOMICS Paper 6: Advanced Macroeconomics

Module 7: Dornbusch's Exchange Rate Overshooting Model
____________________________________________________________________________________________________

Analysis will remain the same whether one considers upward sloping or downward
sloping 𝑒̇ = 0 line. Note that the system of becoming unstable because of interest parity
condition. Exchange rate movements are magnified, rather than getting lowered. Hence,
the movement is away from the 𝑒̇ = 0 line, if the economy is not on that line.Here, it
should be noted that ė = 0 represents an equilibrium situation.

Now, coming to equation (E), which is: 𝑝̇ = 𝜋𝛾(𝑒 − 𝑝). Putting 𝑝̇ = 0, we get e=p.
Thus, 𝑝̇ = 0 is straight 450 line. Figure 2 below shows the motion of the economy along
the 𝑝̇ = 0 line. Along 𝑝̇ = 0 line, output is equal to full-employment level. For the same
level of exchange rate, if the economy is on any point to the left of 𝑝̇ = 0 line, it means
that output is greater than the full-employment level, and hence, prices will rise.
Similarly, any point to the right of 𝑝̇ = 0 line implies output is less than full-employment
level and hence prices will fall. Thus, if the economy is away from 𝑝̇ = 0 line, it will
converge towards it.

Figure 2: Movement of the economy along 𝑝̇ = 0 line

ECONOMICS Paper 6: Advanced Macroeconomics

Module 7: Dornbusch's Exchange Rate Overshooting Model
____________________________________________________________________________________________________

Combining figure 1, and figure 2 into one graph, or in other words, plotting equations (E)
and (F) in one graph will give us the following phase-plane diagram. Equilibrium is
attained at point E. Arrows show how the economy will move if it is away from the
equilibrium. As mentioned in the previous section, there are two roots to the system. The
unstable root will take the economy away from the equilibrium point E. This root will
come up if the economy lands up in section 1 or section 3 of the cross shown in the
figure. The stable root will take the economy towards the equilibrium. This root will
come up if the economy lands up in section 2 or section 4 of the cross shown in the
figure. Thus, one root is a convergent root, and the other is a divergent root.

Figure 3: Phase-Plane Diagram showing the movements of the economy along 𝑝̇ = 0 and
𝑒̇ = 0 lines.

ECONOMICS Paper 6: Advanced Macroeconomics

Module 7: Dornbusch's Exchange Rate Overshooting Model
____________________________________________________________________________________________________

Saddle Path of the System

Saddle path is a curve which shows the combinations of all initial conditions from which
an economy attains equilibrium. This is the only convergent path which will take the
economy to the equilibrium point E. In the following figure, SS line is saddle path.

Figure 4: Saddle Path, SS line in the Phase-plane Diagram

6. Monetary Policy Change and Dornbusch Overshooting Model

The effect of a change in monetary policy on the exchange rates is different under this
model depending upon whether we are considering short-run or long-run analysis.
Dornbusch (1976) says that due to monetary policy change, exchange rates in the short-
run will overshoot their long-run values. We provide a brief analysis of the effects of
monetary policy change in the long run. We will then discuss how exchange rates

ECONOMICS Paper 6: Advanced Macroeconomics

Module 7: Dornbusch's Exchange Rate Overshooting Model
____________________________________________________________________________________________________

overshoot in short-run. Through the analysis we assume that there is an unanticipated

permanent increase in money supply. The analysis for a reduction in money supply can
be understood in a similar manner.

Long-run Analysis
In the long-run, output is at its full-employment level, and prices are flexible. An increase
in money supply leads to an increase in aggregate demand. Since output is fixed at its
maximum potential, it will cause an equi-proportional increase in the price level, making
real money supply same as before. The exchange rate or e will increase, making real
exchange rates same. Thus, there will be no effect on the real variables, real money
supply, real exchange rates, output and real income, and the domestic interest rates.

Short-run Analysis
In the short-run prices are sluggish to adjust. If there is an unanticipated permanent
increase in money supply, exchange will become highly volatile and will depreciate by a
huge amount. The economics behind it is described as follows:

An unexpected permanent increase in nominal supply of money, with prices being sticky
in the short run implies an increase in real money supply in the short run. This would
cause a decrease in the rate of interest to restore equilibrium in the money market in the
short run and as a result, the domestic rate of interest will fall below the world rate of
interest. Consequently the return on domestic assets will become less than that on foreign
assets. In the market for assets, this will be a state of disequilibrium in the short run. How
will equilibrium be restored, especially in the long run? In the long run, the level of
output and demand for it must be at the full employment level of output. The rate of
interest too must come back to its original level. The only change in the domestic
economy will be that the price level would have increased by the same proportion as the
permanent increase in the nominal money supply. With the price level increasing in the
same proportion as the nominal money supply, the level of aggregate demand would be at
the full employment level if and only if the nominal rate of exchange ‘E ‘ were to
increase by the same proportion as the price level, given that the rate of interest is at its
original level. With the rate of interest returning to its original level, which is the same as
the world rate of interest, there would be a restoration of long run equilibrium in all
markets if the nominal rate of exchange ‘E’ were to indeed increase by the same
proportion by the price level. This is known to the economic agents. Hence once it has
been realized that the nominal money supply has been increased by a certain given level,
they would be able to calculate correctly the proportional increase in nominal rate of
exchange.

However, the nominal rate of exchange does not increase directly to that level in the short
run, but increases by a greater amount. This is because in the short run the price level
does not increase, and therefore the real money supply and the domestic rate of interest
remain above and below their long run levels respectively. Under these circumstances,
international capital movements would be in equilibrium only if the rate of return on
ECONOMICS Paper 6: Advanced Macroeconomics
Module 7: Dornbusch's Exchange Rate Overshooting Model
____________________________________________________________________________________________________

domestic assets were to be the same as the return on foreign assets. However, the
domestic rate of interest and hence the return on domestic assets is lesser than the world
rate of return, which is equal to the world rate of interest. The only way in which the rate
of return on domestic assets can equal the world rate of interest in the short run, is for
there to be an expected appreciation (or a reduction in the nominal rate of exchange) to an
extent equal to the difference between the world rate of interest and the domestic rate of
interest. The nominal rate of exchange can only fall to its expected and higher level only
if in the short run it rises to a greater extent than its long run equilibrium level.
Remember, that the rate of exchange adjusts much more rapidly than the price level.
Hence the rate of exchange increases to it’s a much higher level even though and indeed
because the price level has not increase. This is what constitutes the phenomenon of
overshooting. This is a heuristic explanation, which Dornbusch explained by means of a
rigorous model.

To visualize this process graphically, see figure 5 below. Figure 5 explains the effect of
an increase in money supply in short-run through the phase-plane diagram. The economy
is at equilibrium at point E, where 𝑝̇ = 0 and 𝑒̇ = 0 lines intersect. S1S1 is the saddle
path. Suppose there is an increase in money supply. Money supply appears as a shift
variable in 𝑒̇ = 0 line. With an increase in money supply, exchange rate will depreciate.
Thus, 𝑒̇ = 0 line shifts. It shifts from 𝑒0̇ = 0 to 𝑒1̇ = 0. As a result, the solution of the
system of equations (E) and (F) (explained above) will change, leading to a new saddle
path of S2S2. The new equilibrium should have been at point E1. However, prices are
slow to adjust with the change in money supply, but exchange rates are not. The economy
does not move to point E1 immediately. Thus, initially, economy will move to the point
E2, where 𝑒1̇ = 0 line and S2S2 intersect. Because exchange rates are flexible, at point E2,
they have fully adjusted. Basically, the exchange rates have depreciated by a large
amount, than it should have been if the prices were not sluggish. The sluggishness of
prices has been counterbalanced by over movement in exchange rates. This over
movement is what Dornbusch (1976) calls overshooting of exchange rates. The new
equilibrium exchange rates should be e1, but it overshoots this value, and settles down at
e2. It is when the price level start adjusting that the economy will reach its new long-run
equilibrium at point E1. Thus, in the short-run, an increase in money supply moves the
economy from point E0 to E2. In the long-run, due to adjustment of price level, the
economy will move from E2 to E1.

ECONOMICS Paper 6: Advanced Macroeconomics

Module 7: Dornbusch's Exchange Rate Overshooting Model
____________________________________________________________________________________________________

Figure 5: An increase in money supply and exchange rate overshooting

To visualize the time path of different variables, see figure 6 and figure 7 below. At time
t0, money supply increases from m0 to m1. In the long-run, there is an equal increase in
the exchange rates and the price level. However, in the short-run, at time t0, exchange
rates jump to e2. Since prices are slow to adjust, they increase at a slower pace to their
long-run value of p1. As a result, exchange rates get back to their long-run level of e1
when prices also get fully adjusted.
If initially, output was at its full-employment level, an increase in money supply will
increase output beyond its full-employment level. It is when prices start adjusting, output
will return back to its long-run level (see figure 7).

ECONOMICS Paper 6: Advanced Macroeconomics

Module 7: Dornbusch's Exchange Rate Overshooting Model
____________________________________________________________________________________________________

Figure 6: Path Diagram for Money Supply (Panel A), Exchange Rates (Panel B), and
Prices (Panel C)

ECONOMICS Paper 6: Advanced Macroeconomics

Module 7: Dornbusch's Exchange Rate Overshooting Model
____________________________________________________________________________________________________

Figure 7: Path Diagram for Output

7. Summary

 Dornbusch Exchange Rates Overshooting Model shows why exchange rates are
volatile in the short-run; even if there are flexible exchange rates and agents have
rational expectations.
 The model combines Keynesian short-run framework with the Monetarists’ long-
run analysis to link the theory with the real world.
 The major assumptions of the model are sticky prices, perfect capital mobility,
flexible exchange rates, and perfect foresight of the agents.
 Mathematically, six equations define the structure of this model. Four equations
represent the equilibrium of capital market, money, and goods market, and the
Phillips Curve, respectively. The two equations 𝑝̇ = 0 and 𝑒̇ = 0 show the
dynamics that lead the economy to the equilibrium.
 An increase in money supply, in the short-run depreciates the domestic currency
well above its long-run level, causing overshooting.
 In the long-run, an increase in money supply has no effect on the real variables.
Only nominal variables change.

ECONOMICS Paper 6: Advanced Macroeconomics

Module 7: Dornbusch's Exchange Rate Overshooting Model