Expectations and Exchange Rate Dynamics

This 1976 Journal of Political Economy paper by Rudiger Dornbusch builds a small open-economy model in which capital is perfectly mobile and asset markets clear instantly, but the price of domestic goods adjusts only gradually, and asks what a perfect-foresight (rational-expectations) exchange rate path looks like when a central bank permanently increases the money supply. Because uncovered interest parity must hold at every instant while goods prices are sticky, the entire short-run burden of adjusting to a monetary expansion falls on the exchange rate and the interest rate: Dornbusch shows that the exchange rate must depreciate immediately by more than its eventual long-run depreciation – overshooting – so that the public rationally expects a subsequent appreciation large enough to offset the now-lower domestic interest rate. As goods prices gradually rise toward their new long-run level, real balances fall, the interest rate rises back up, and the exchange rate appreciates back toward (but never quite reaching, in finite time) its long-run value; the model thus predicts an episode in which rising domestic prices are accompanied by an appreciating currency, the opposite of the naive comovement often assumed. Dornbusch derives the exact magnitude of overshooting in closed form as a function of the model’s structural parameters (the interest-elasticity of money demand, the price-elasticity of goods demand, and the assumed rational-expectations adjustment speed), and shows that if short-run output is allowed to respond to demand rather than being fixed, the resulting dampening of interest-rate movements can shrink or even reverse the overshooting result, so that a monetary expansion could actually raise interest rates in the short run.

Rudiger Dornbusch | Macro Paper Warehouse

Expectations and Exchange Rate Dynamics