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Dornbusch

FranzFranz CanadaPosts: 14 Associate
Could someone please help me understand the Dornbusch overshooting model (pg541 - vol 1)? I remember in univ, my prof had a great diagram but I can't find it.

Comments

  • 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.
    SophieZeeFranz
  • @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...
    This is CFA!!!
    SophieZeeFranz
  • ZeeZee London - UKPosts: 1,529 Jr Partner
    :-bd @reena @fabian

    @Franz, let us know if that helps or if you'd like to go deeper!
    Homer: He might have all the money in the world, but there’s one thing he can’t buy. Marge: What’s that? Homer: .......A dinosaur The Simpsons
  • @zee, I had never heard of this either. Is this a new addition to the level 2 curriculum?
    “Once you decide on your occupation you must immerse yourself in your work. You have to fall in love with your work. Never complain about your job, you must dedicate your life to mastering your skill. That’s the secret of success and the key to being regarded honorably. I’ve never once hated my job, I fell in love with my work and gave my life to it.”—Jiro Ono
  • christinechristine On the movePosts: 631 Sr Portfolio Manager
    @franz let us know if you're talking about pg541 of Schweser or CFA curriculum..?
  • FranzFranz CanadaPosts: 14 Associate
    Yes, it's the CFAI level 2-book 1. Thank you so much for the help guys! Fabian's and Reena's posts are all I need for the exam!! You guys are amazing!
    ZeeSophie
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