The Dornbusch Model, Trade Flow Lags, and Exchange Rate Overshooting

Abstract

This paper reconsiders the exchange rate overshooting proposition first advanced in Dornbusch's seminal work on exchange rate dymanics. The basic findings that monetary expansion causes exchange rate overshooting and that fiscal expansion does not are reconsidered in the context of Dornbusch's model modified to allow trade flows to respond with a lag to movements in the exchange rate. It turns out that, because of the trade flow lags, fiscal expansion always produces exchange rate overshooting (as does monetary expansion, as expected). This suggests that fiscal policy may be a more important source of exchange rate variability than is commonly believed. This paper reconsiders the exchange rate overshooting proposition first advanced in Dornbusch's seminal work [2] on exchange rate dynamics. The basic findings that monetary expansion causes exchange rate overshooting and that fiscal expansion does not are reconsidered in the context of Dornbusch's model modified to allow trade flows to respond with a lag to movements in the exchange rate. The introduction of such a lag is a potentially important qualification in view of the substantial amount of empirical evidence [5] supporting this phenomenon. In fact, it turns out that, because of the trade flow lags, fiscal expansion always produces exchange rate overshooting. This suggests that fiscal policy may be a more, important source of exchange rate variability than is commonly believed. With respect to monetary expansion, however, it remains true that overshooting occurs as in the Dornbusch model.1