Dornbusch Exchange Rate Overshooting Model

 

Table of Contents

Introduction. 3

Understanding the Overshooting Model 3

Conclusion. 4

Reference List 6

Introduction

Like various other models, the overshooting model, also known as the Dornbusch model, helps with the fluctuations caused by the change in monetary supply. Such a concept is required in understanding economic changes and fluctuations. The purpose of this discussion is to analyse the different aspects of the overshooting model and understand its assumptions and implications. 

While understanding the details of the overshooting model, the analysis will further constitute the intactness of the hypothesis. 

Understanding the Overshooting Model

The overshooting model of Dornbusch’s model is the excessive short-term exchange rate movement due to changes in the money supply caused by the stickiness of price (WallStreetMojo, 2022). In simple words, using the concept of price stickiness the overshooting model explains the increase in volatility of currency exchange rates. 

The argument made by the overshooting model is that the foreign exchange rate will overreact to fluctuations in the monetary policy temporarily as compensation for the sticky prices of the goods in the market. According to the overshooting model the equilibrium is first achieved by the market whenever there is a decrease in interest rates caused by the monetary policy of a country (WallStreetMojo, 2022). However, a short-term equilibrium will be reached based on the sticky nature of prices. 

Initially, the observation related to the change in exchange rate relates to the overshooting of the same rate by a high level as it remains based on the price of old goods. With adjustments by the product market, the exchange rate will adjust. It is for such a reason, that the goods prices and the exchange rate will be achieved in the equilibrium of long-run. Hence, there comes a high volatility in the exchange rate of the economy. 

Over time, the overshooting model has not only been used to understand the volatility in the economy but also to answer some significant questions. For instance, with the assistance of the Dornbusch model, Online Assignment Help Sheffield it is simple to understand the transmission mechanism in the open economy of a tightening of monetary policy (Ruth, 2020). For this, the explanation provided by the overshooting model consists of the central bank bringing about a rise in interest rate, along with a rise in positive interest differential relative to other nations. With this explanation, the overshooting model brings a combination of purchasing power parity, uncovered interest parity, and liquidity effects with its hypothesis (Ruth, 2020). 

Even after the use of the overshooting model providing explanations of different economic conditions, over time, there has been some doubt about its usefulness with time. Over time, there has been an onslaught of many new approaches and ideas, but it is believed that the Dornbusch model or the overshooting model is still alive and relevant. However, now, there have been variants of the Dornbusch model which go beyond just overshooting (Rogoff, 2001). With the variants of the Dornbusch model, there are still some assumptions that have risen. These assumptions in some way relate to the original assumptions of the overshooting model. 

The assumptions of the overshooting model include the flexibility exhibited by exchange rates. In another assumption, there is an applicability of the uncovered interest parity. For instance, the difference between the Eurozone interest and the United States interest rates will be equal to the depreciation rate expected from the US dollars (WallStreetMojo, 2022). Another assumption is that the demand for money depends on the interest rate and the production output. The fourth assumption is that in the short run, the prices of the goods remain fixed, however, there is a slow adjustment in the long run to counter the financial shocks (WallSteetMojo, 2022). 

To some degree, the use of the terminologies of the Dornbusch model has been common in modern macroeconomics. As a result, the overshooting model is found essential in predicting macroeconomics and the future responses of an economy concerning the fluctuation in monetary prices. The Dornbusch model explains an important regularity in the fact that there is a higher volatility in the experience of exchange rates than the interest rates and price of goods. 

Conclusion

The purpose of this discussion had been to analyse the different aspects of the overshooting model and understand its assumptions and implications. The overshooting model has its usefulness in explaining the different movements that occur in exchange rates due to changes in the monetary supply. Over time, it is natural to receive variations of any old model. But the popularity of the Dornbusch model has remained the same with time, due to its ability to explain the volatility rate. 

 Reference List

Overshooting model (2022) WallStreetMojo. Available at: https://www.wallstreetmojo.com/overshooting-model/#overshooting-model-of-exchange-rate-explained (Accessed: March 1, 2023). 

Rogoff, K. (2001) Dornbusch's overshooting model after twenty-five years, the Mundell-Fleming lecture by Kenneth Rogoff, economic counselor and director of the IMF Research Department, IMF. Available at: https://www.imf.org/en/News/Articles/2015/09/28/04/53/sp112901 (Accessed: March 1, 2023). 

Rüth, S.K., 2020. Shifts in monetary policy and exchange rate dynamics: Is Dornbusch's overshooting hypothesis intact, after all?. Journal of International Economics, 126, p.103344. Available at: https://www.econstor.eu/bitstream/10419/234997/1/1683318846.pdf (Accessed: March 1, 2023). 

  

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