Author: Alan A. Powell
Dornbusch's 1976 overshooting exchange rate model (hereafter, DBM) has long been known to underpin several large macro models, including the Murphy Model (MM). But the dynamic adjustment paths of variables in MM differ markedly from those in DBM, even qualitatively. A leading case in point is the exchange rate which in MM undershoots its new long run-equilibrium value after the injection of a monetary shock, and then actually moves away from this equi-librium for a time before approaching it via a damped cyclical adjustment path (whereas the corresponding path in DBM is monotonic).
This paper gives a simplified account of how this comes about. The emphasis is not so much on theoretical rigour but on providing a convincing practical demonstration. Using the simplest form of DBM as a starting point, it is shown how one can develop a miniature model exhibiting an MM-like response to a monetary shock. The key idea is that aggregate demand does not respond instantaneously (as in DBM) to shocks in the macroeconomic environment, but shows some degree of inertia. Nothing more is required to reconcile the qualitative dynamics of MM with DBM.
JEL classification: E17, E32
Working Paper Number IP-69 can be downloaded in PDF format.
To print this you will need the Adobe Acrobat Reader.
There is also an MS Excel demonstration file for the Extended Dornbusch Model (EDBM) that can be downloaded as a self-extracting archive (download file). [Save this as edbmxlw.exe and then double-click on this to extract the Excel file edbm.xlw which can then be opened in Excel.] You will need MS Excel 5 or higher with the Solver add-in installed.
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