The Dornbusch 1976 Model is a combination of the monetary model and Mundell-Fleming model where it considers the short run principles of the Mundell Fleming (fixed priced model) model and long run principles of the monetary model (flexible price model). It is predicated around exchange rate volatility stating that give a shock, financial markets become hyperactive and the exchange rate overshoots its long run equilibrium levels. Exchange rates are said to ‘overshoot’ when its immediate response to a change is greater than its long run response; that is, short term deviations from long run equilibrium, although this couldn’t happen if exchange rates were fixed as there would be no immediate impact on rates. Such scenario can occur when monetary policy changes impact interest rates instantly, but prices are sticky in the short run (delayed response in prices), therefore after the impact phase, the model moves to adjustment phase where long run equilibrium is restored.

 

Main observations of the model

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• Flexible exchange rates allow financial markets adjust to shocks quicker than the goods market due to short run sticky prices therefore financial markets compensate for sluggish adjustment of the goods market - otherwise known as exchange rate overshooting.

• However, Long run prices (nominal and real) fully adjust returning all variables to equilibrium levels. 

• According to the model, exchange rate volatility is a result of instability in monetary policy contrary to the popular belief that the world expects exchange rate volatility to smoothly mirror inflation differentials. 

 

Assumptions of the Dornbusch model

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• The model assumes a small open economy where foreign interest rates and foreign prices are exogenous variables

• Certain assumptions are made about the goods market; that is, prices are sticky but only in the short run. Long run adjustments for the prices of factors or production and output occur so the market can once again clear. The aggregate supply curve is in long equilibrium once it is fully vertical however during the adjustment phase, it begins horizontally and steepens until equilibrium is restored. 

• Financial markets react immediately, in particular, investors are risk neutral and with international capital mobility, UIP always holds. However, short run deviations occur from long run equilibrium in exchange rates.

 

Expectations 

 

• Expectations are endogenous and are rational 

• The expected change in the exchange rate is a function of it short run deviation:

 

Where  is the parameter reflecting the sensitivity of market expectations of over or undervaluation relative to equilibrium and , if  is large, the exchange rate will converge quicker to its equilibrium level

 

Long-Run Equilibrium

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• Aggregate supply = Aggregate Demand. Assuming the economy operates at full employment, there will be no pressure on prices to change. 

• Domestic and Foreign Interest rates are equal meaning there is no incentive for investors to choose one or the other, thus eliminating the threat of exchange rate movements. Further, the model assumes the real exchange rate is at its long-run equilibrium. 

• Money neutrality i.e. money supply changes are proportionally accompanied by changes in nominal prices and the nominal exchange rate.