Download Document

dr Bartłomiej Rokicki
Chair of Macroeconomics and International Trade Theory
Faculty of Economic Sciences, University of Warsaw
dr Bartłomiej Rokicki
Open Economy Macroeconomics
Main assumptions of the model
• Small open economy.
• Flexible exchange rates, perfect capital mobility.
• The Dornbusch model is a hybrid model:
o Short-run features of the Mundell-Fleming model (price rigidities)
o Long-run features of the flexible price model (e.g. economy is at
full employment in the long run) with endogenous expectations
• We analyse the impact of monetary policy on the small open
economy in order to explain why exchange rates move so sharply
from day to day.
• The exchange rate is said to overshoot when its immediate response
to a disturbance is greater than its long-run response.
dr Bartłomiej Rokicki
Open Economy Macroeconomics
Exchange rate volatility
Changes in price
levels are less
volatile, suggesting
that price levels
change slowly.
Exchange rates are
influenced by
interest rates and
expectations, which
may change rapidly,
making exchange
rates volatile.
dr Bartłomiej Rokicki
Open Economy Macroeconomics
Financial markets equilibrium
• The economic explanation of overshooting comes from the interest
parity condition:
1
ee − e
e
1 + i = (1 + i*)e ⇒ i = i * +
e
e
ee − e
> 0 . That is, a positive
• The implication is, if i > i* , then
e
interest rate deferential leads us to expect a depreciation.
• Yet, the data shows the opposite (forward discount puzzle).
• Money market equilibrium is given by:
M / P = Y α e − βi
• Then, taking the logs we get:
log M − log P = α log Y − β i
dr Bartłomiej Rokicki
Open Economy Macroeconomics
Financial markets equilibrium (2)
•
Plugging the interest rate parity into the money market equilibrium equation we
have:
e
log M − log P = α log Y − β i * − β
•
e −e
e
Still, in a long-run equilibrium we know that the economy must be at full
employment level with constant prices and constant exchange rate. So the
above simplifies to:
e
log M − log P = α log Y − βi *
•
where
Then, solving for prices we get:
e −e
=0
e
log P = log M − α log Y + βi *
•
The above implies that any change in the money supply is matched by a
corresponding change in the price level.
•
Finally, plugging together the short-run and the long-run we receive:
ee − e
log P = log P − β
e
and
ee − e 1
= (log P − log P )
e
β
dr Bartłomiej Rokicki
Open Economy Macroeconomics
Goods markets eqilibrium
• Aggregate demand is determined by the standard ISLM mechanism:
log Y = log A + h(log e + log P * − log P)
(log e + log P * − log P) = log q
where A stays for exogenous spending (e.g. public expenditure)
• Short-run sticky prices are represented by a Phillips curve type
relationship:
∆P = Y − Y
• The term ∆P is the change in the price level and Y is the long-run output
level.
• As usual, when Y > Y then ∆P > 0 ,i.e., inflation.
dr Bartłomiej Rokicki
Open Economy Macroeconomics
Money and prices in the long-run
•
How does a change in the money supply cause prices of output and
inputs to change?
•
Excess demand - an increase in the money supply implies that
people have more funds available to pay for goods and services.
•
o
To meet strong demand, producers hire more workers, creating a strong
demand for labour, or make existing employees work harder.
o
Wages rise to attract more workers or to compensate workers for
overtime.
o
Prices of output will eventually rise to compensate for higher costs.
Inflationary expectations - if workers expect future prices to rise due
to an expected money supply increase, they will want to be
compensated.
dr Bartłomiej Rokicki
Open Economy Macroeconomics
The impact of monetary expansion in a short-run
• Because prices are sticky, the goods markets adjust slowly, while
financial markets adjust instantaneously.
• The money supply increase shifts the LM to the right, decreasing the
interest rate (the usual liquidity effect).
• The increase in M (forgetting i's reaction and that there are sticky prices)
induces a current depreciation of the domestic currency, so the nominal
exchange rate increases.
i
LM0
LM1
i*
BP
IS0
Y
Y
dr Bartłomiej Rokicki
Open Economy Macroeconomics
The impact of monetary expansion in a short-run (2)
•
•
•
•
ee − e
Given the interest rate parity ( i = i * +
), the fall in i → Δee < 0,
e
i.e. it must be associated with an expected future appreciation.
In order to generate an expected appreciation, the currency overdepreciates (i.e. overshoots) vs. it's long-run level.
The currency depreciation, together with ΔP = 0 in the short-run,
implies that q rises, and IS shifts to the right.
The shifts in IS and LM shift aggregate demand, which equals shortrun aggregate supply. There is an increase in output produced.
i
LM0
LM1
i*
BP
Y
IS1
IS0
Y
dr Bartłomiej Rokicki
Open Economy Macroeconomics
The impact of monetary expansion - transition to the long-run
•
Excess aggregate demand pushes up prices.
•
The increased price level reduces real money supply so the LM shifts back to its
initial equilibrium. The interest rate rises to its initial position, and as this
happens the domestic currency appreciates (e falls).
•
The increase in prices, together with the currency appreciation, reduces the
domestic economy's competitive advantage in the goods market, and IS shifts
back to its initial position.
•
We return to the initial real equilibrium with:
o Increased prices
o A nominal exchange rate depreciation
o The real exchange rate at its initial level
i
LM0
LM1
i*
BP
Y
IS1
IS0
Y
dr Bartłomiej Rokicki
Open Economy Macroeconomics
Graphical analysis using the IRP model
e
• We start in a long-term equilibrium
with given M, P, Y, i and e.
RETh
e*
RETf ( E1e , i*)
i1
M1
P1
L(Y, i)
real money stock
i
dr Bartłomiej Rokicki
Open Economy Macroeconomics
Graphical analysis using the IRP model (2)
• Expansionary monetary policy
shifts the real money supply curve
downwards.
• As a result there is a fall in
domestic nominal interest rate and
the RETh curve shifts to the left.
e
RETh
e2
RETf ( e 2e , i*)
e1
RETf ( e 1e , i*)
i2
• Furthermore, due to change in
monetary policy, an expected
exchange rate increases so RETf
curve shifts upwards.
M1
P1
• Hence, the nominal exchange rate
increases from e1 to e2.
M2
P1
i1
L(Y, i)
real money stock
i
dr Bartłomiej Rokicki
Open Economy Macroeconomics
Graphical analysis using the IRP model (3)
• An increase in production above its
long-run level leads to an increase
in prices.
• So, real money supply will fall to its
initial level (in a long term P
increases proportionally to M).
e
RETh
e2
e3
RET f ( e 2e , i*)
e1
RET f ( e 1e , i*)
• This leads to an increase in
nominal interest rate and shifts the
RETh curve to the right.
i2
• Hence, the nominal exchange rate
falls from e2 to e3.
M2
P2
• In new long-term equilibrium we
have higher P, M and e. Production
and i remain constant.
M2
P1
i1
L(Y, i)
real money stock
i
dr Bartłomiej Rokicki
Open Economy Macroeconomics
Conclusions
• A permanent increase in a country’s money supply causes a
proportional long run depreciation of its currency.
•
However, the dynamics of the model predict a large depreciation first
and a smaller subsequent appreciation.
• A permanent decrease in a country’s money supply causes a
proportional long run appreciation of its currency.
•
However, the dynamics of the model predict a large appreciation first
and a smaller subsequent depreciation.
• Exchange rate overshooting helps explain why exchange rates are so
volatile.
• Overshooting occurs in the model because prices do not adjust
quickly, but expectations about prices do.
dr Bartłomiej Rokicki
Open Economy Macroeconomics
r
LM0
LM1
r*
BP
IS1
IS0
Y0
Y1
Y
dr Bartłomiej Rokicki
Open Economy Macroeconomics
Question1. Answer the following questions applying the Dornbusch
model of overshooting exchange rates.
a) In the literature, Dornbusch’s model is referred to as an exchange
rate “overshooting” model. Why is it referred to in this way? What is
the behavioral logic that underpins the model and its predictions?
b) Consider an expansion of the domestic money supply when the
system is in equilibrium. Show what effect this will have on the interest
rate, domestic prices, and the exchange rate.
c) Suppose you were an advisor to a group of agricultural exporters.
On the basis of the Dornbusch model would you advise them to lobby
for “tight” or “loose” monetary policy? Why?
dr Bartłomiej Rokicki
Open Economy Macroeconomics
Question 2. Suppose that the government of a small open economy, due to high
inflation, decides to permanently decrease money supply.
• Applying the Dornbusch model explain what will be the impact of such a policy
on nominal and real exchange rate in a short and a long run.
• Analyze the evolution of real money supply, prices and interest rates. Recall
the assumptions of the model that lead to such results.
The answer should include the necessary diagrams.
Question 3. Let’s assume that the demand for domestically produced output is
also a function of an exogenous component, G (you can think of it as a public
spending component).
Imagine that the government increase permanently public spending from G = 0 to
G = G. Does the equilibrium value of the real exchange rate and the nominal
exchange rate change? Does the nominal exchange rate overshoot its long-run
value?
dr Bartłomiej Rokicki
Open Economy Macroeconomics
Question 4. Consider the simplified version of the Dornbusch model where prices
are fixed in the first period and perfectly flexible from period 2 onwards. Derive the
response of the nominal and real exchange rates to the following shocks:
(a) a permanent increase in the rate of money growth;
(b) a permanent increase in the full employment output level. Distinguish between
the case in which the elasticity of desired expenditure to the real exchange rate (h)
is: (i) equal to one; (ii) less than one.
Question 5. Consider the Dornbusch model as presented above and describe the
adjustment mechanism in the following experiments.
a) suppose that y, the long-run level of output, increases to y1. Do you expect to
observe overshooting in the nominal exchange rate?
b) suppose now that the sensitivity of market expectations to over- or
undervaluation of the currency relative to the equilibrium exchange rate, increases.
Describe the adjustment mechanism following this unexpected change.
c) Describe the adjustment path of the economy following a change in the interest
rate elasticity of money demand.