Dornbusch

Hi @Franz. Welcome to the forum.

Basically, Dornbusch model aims to explain the high volatility of floating exchange rates due to rigid/ ‘sticky’ prices in the short run.

There are a few assumptions in this model:

• Capital is perfectly mobile.
• Deviations from purchasing power parity is allowed in the short run, but will return to PPP in the long run.
• Prices are ‘sticky’ in the short run for the goods market, but financial markets adjust instantaneously.

For your graphical question, check out the last 3 pages of this paper, I hope it helps illustrate the FX overshooting in the short run.

:-bd @reena @fabian

@Franz, let us know if that helps or if you’d like to go deeper!

@zee, I had never heard of this either. Is this a new addition to the level 2 curriculum?

@Franz welcome! I had a minor heart attack when I saw your question was in Level 2 – I’d never heard of the Dornbusch model before! Looked it up and here’s how I understand it.

Dornbusch (among other models) is one model used to explain how monetary and fiscal policies affect exchange rate movements. It’s a variation of the monetary approach.

The monetary approach assumes that in a policy change, output is fixed, and prices with change to reflect policy changes. e.g. if there is an increase in money supply, output stays the same, prices will increase, and domestic currency will drop.

Dornbusch argues that price levels take time to adjust, so short term prices are assumed to be fixed, but FX adjusts instantly. This means that the domestic currency volatility will be much higher with this new assumption, as short term prices take some time to adjust to new changes, there will be some overshoot and undershoot of currency FX rates.

Others please feel free to correct/comment…

@franz let us know if you’re talking about pg541 of Schweser or CFA curriculum..?