Expectations and exchange rate dynamics after a decade of floating

Abstract

Dornbusch's model of expectations and exchange rate dynamics has been a theoretical success and an empirical failure. The premise underlying this paper is that the price and exchange rate dynamics inherent in his model cannot be captured by single equation methods. To capture these dynamics, we estimate Dornbusch's model using constrained maximum likelihood methods which incorporate cross equation restrictions derived from the structural equations and assumption of rational expectations. Our central result is that the estimation of Dornbusch's model is much more successful than single equation methods have led us to believe.