Dornbusch Model free essay sample

This can explain what appears to be excessive volatility in Exchange rates. The novel feature of the model is the explicit treatment of preferential speeds of adjustment in the goods and asset markets. Asset markets adjust quickly, almost instantaneously to shocks, while goods markets are sluggish, and adjustment is slow. The Doorknobs Model is a hybrid, it combines the short run features as the Mendel-Fleming model, which it not takes no account of expectations and the price level is fixed; and the long-run characteristics of the monetary model.What Professor Ruddier Doorknobs could observe during his exploration was that while product markets adjust only slow, financial markets appear to adjust far more rapidly almost instantaneously, in fact. The consequence of the real world is that financial markets have to over-adjust to perturbations, for compensating the stickiness of prices in goods markets. As a consequence of the delayed of the beginning of product prices, the interest rate, aggregate demand and the real Exchange rate return to their original values. Like in the monetary model, all the real magnitudes ends where they started, and the nominal Exchange rate at a new long-term level that reflects the proportionate change in the money supply. One characteristic of the overshooting model is that is likely to respond to a real perturbation. Doorknobs model has some appeal because Of the following reasons: 1. It is a model that is at once simple, elegant and readily understood. 2.While analyzing the effect of a monetary expansion, an important distinction is made between an initial phase during which only financial variables adjust and a later phase during which the real economy begins to adjust. A monetary expansion in Troubadours model Will instantly adjusts interest rates and exchange rates; later the price level begins to respond to the monetary expansion. 3. This model assume that the publics expectations about exchange rates are fully rationally formed.This implies that observing an increase in the money stock, they can also know the end result, they can also know the time path of adjustment of the economy towards this end point. In the short-run, they have perfect foresight. 4. According to what Doorknobs said, the only real adjustment that occurs in the later stages is the price adjustment. 5. Doorknobs shows that the exchange rate must initially overshoot its long-run level. It is also where we frequently observe what looks like excessive exchange rate movement. 6. Doorknobs assumes that prices are sticky in the short-run but ultimately adjust fully to he increase in the money stock.At the same time, Troubadours long-run results are that prices will increase in proportion, that interest rates will return to their original levels and that the currency will also devalue in proportion. B. EQUATIONS. GOODS MARKET: a) Short term and at any time: 1. Real demand for goods: Hyde q = s -?p (real exchange rate). The equation captures the essential link between aggregate demand for domestic output and the real exchange rate. As we know, the higher the real exchange rate, the more competitive are I-J products and henceforward the greater the demand. 2. Demand adjustment: D y constant.This equation says that the broader the gap among demand and capacity output, y, the higher the rate of inflation, C. Income is taken as fixed exogenously at the full employment level. If the demand diverges from that level, the outcome is a protracted change in the level of the prices in the economy. B) Long term stationary equilibrium: 1. In the long-run equilibrium our rate of inflation is zero. The only thing in the model that changes the real exchange rate is growth in capacity output. O O MONEY MARKET: 1. Demand for money: m -p = KY- Ir. Is a simply log linear formulation of the demand for money. Long term stationary equilibrium domestic price: = m KY+ Ir. Long term price level is determined by the long term income, and the stationary interest rate. The expected rate of depreciation is zero. The exchange rate is static and is not expected to change because it is at its equilibrium level. What this equation says is that the equilibrium price level is the ratio of the money stock to the level of demand when it is at its long-run c) Long term stationary equilibrium exchange rate: = (h-l k) y + m + Ir. The nominal exchange rate settles at the level. INTERNATIONAL FINANCIAL MARKETS.As I have already mentioned, financial markets adjust instantaneously. In particular, investors are risk neutral, so that uncovered interest rate parity (RIP) holds at all times. In the short run, the exchange rate will deviate from the equilibrium level, as a result of the sluggishness with which goods prices react to a disturbance. R = + Ease, where r is the interest rate of I-J, r* is the exogenously given US interest rate and Ease is the expected rate of depreciation in the value of the pound sterling relative to the dollar. B) Short term adoptive expectations about movement of the exchange rate ; Interest Rate Parity Line:Ease = 0 (S s), r = 0 (S s) + c) Long term stationary and expectation equilibrium: O = Ease = r r*. When the equilibrium is stationary, there are no expectations of any changes; because all the variable are expected to remain stationary. 2. Solve the model and derive the elements of the diagram which shows the dynamic adjustment after an exogenous shock. As Copeland says in his book, the aggregate supply curve is horizontal in the immediate impact phase, increasingly steep in the adjustment phase and, ultimately, vertical in long- r un equilibrium. In the long-run, the exchange rate is at its equilibrium level.Nevertheless, in the short-run, the level of the prices are fixed, because of the inherent rigidities that are so typical Of markets for labor and goods. The shocks that produce the movements in the nominal exchange rate are associated with changes in the real exchange rate and hence with current account deficits or surpluses. As Doorknobs model explains, over time, the economy moves back to its long-run real exchange rate, as a result of movements in both the nominal exchange rate and the price level. 3. Explain the dynamics in a diagram. For explaining the dynamics in a diagram we are going to use the graphic of he question before. As we can see in the graphic, the figure (a) illustrates the path taken by the exchange rate to satisfy RIP, where the exchange rate decrease. As a consequence of this, we can see in figure (b) how the decrease of the exchange rate produce a higher demand of outputs for the ASK. In figure (c) we can see the APP diagram, where it is assumed that the UK current account clears at the real exchange rate. Combinations of P and S above the line, where the real value of the pound is higher than Quo and that means that the UK is uncompetitive, and as a consequence it runs a current account deficit.