dr Bartłomiej Rokicki Chair of Macroeconomics and International Trade Theory Faculty of Economic Sciences, University of Warsaw

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1 dr Bartłomij Rokicki Chair of Macroconomics and Intrnational Trad Thory Faculty of Economic Scincs, Univrsity of Warsaw

2 dr Bartłomij Rokicki Opn Economy Macroconomics Small opn conomy. Main assumptions of th modl Flxibl xchang rats, prfct capital mobility. Th Dornbusch modl is a hybrid modl: o Short-run faturs of th Mundll-Flming modl (pric rigiditis) o Long-run faturs of th flxibl pric modl (.g. conomy is at full mploymnt in th long run) with ndognous xpctations W analys th impact of montary policy on th small opn conomy in ordr to xplain why xchang rats mov so sharply from day to day. Th xchang rat is said to ovrshoot whn its immdiat rspons to a disturbanc is gratr than its long-run rspons.

3 dr Bartłomij Rokicki Opn Economy Macroconomics Exchang rat volatility Changs in pric lvls ar lss volatil, suggsting that pric lvls chang slowly. Exchang rats ar influncd by intrst rats and xpctations, which may chang rapidly, making xchang rats volatil.

4 Financial markts quilibrium dr Bartłomij Rokicki Opn Economy Macroconomics Th conomic xplanation of ovrshooting coms from th intrst parity condition: 1 1+ i= (1+ i*) i= i * + Th implication is, if i > i*, thn > 0. That is, a positiv intrst rat dfrntial lads us to xpct a dprciation. Yt, th data shows th opposit (forward discount puzzl). Mony markt quilibrium is givn by: M / P= Y α βi Thn, taking th logs w gt: log M log P=α logy βi

5 Financial markts quilibrium (2) dr Bartłomij Rokicki Opn Economy Macroconomics Plugging th intrst rat parity into th mony markt quilibrium quation w hav: log M log P= α logy βi * β Still, in a long-run quilibrium w know that th conomy must b at full mploymnt lvl with constant prics and constant xchang rat. So th abov simplifis to: logm log P =α logy βi* whr = 0 Thn, solving for prics w gt: log P = logm α logy + βi* Th abov implis that any chang in th mony supply is matchd by a corrsponding chang in th pric lvl. Finally, plugging togthr th short-run and th long-run w rciv: 1 log P = log P β and = (logp log P) β

6 Goods markts qilibrium dr Bartłomij Rokicki Opn Economy Macroconomics Aggrgat dmand is dtrmind by th standard ISLM mchanism: logy = log A+ h(log+ log P* log P) (log + log P* log P) = logq whr A stays for xognous spnding (.g. public xpnditur) Short-run sticky prics ar rprsntd by a Phillips curv typ rlationship: P= Y Y Th trm P is th chang in th pric lvl and Y is th long-run output lvl. P> 0 As usual, whn Y > Y thn,i.., inflation.

7 Mony and prics in th long-run dr Bartłomij Rokicki Opn Economy Macroconomics How dos a chang in th mony supply caus prics of output and inputs to chang? Excss dmand - an incras in th mony supply implis that popl hav mor funds availabl to pay for goods and srvics. o To mt strong dmand, producrs hir mor workrs, crating a strong dmand for labour, or mak xisting mploys work hardr. o Wags ris to attract mor workrs or to compnsat workrs for ovrtim. o Prics of output will vntually ris to compnsat for highr costs. Inflationary xpctations - if workrs xpct futur prics to ris du to an xpctd mony supply incras, thy will want to b compnsatd.

8 dr Bartłomij Rokicki Opn Economy Macroconomics Th impact of montary xpansion in a short-run Bcaus prics ar sticky, th goods markts adjust slowly, whil financial markts adjust instantanously. Th mony supply incras shifts th LM to th right, dcrasing th intrst rat (th usual liquidity ffct). Th incras in M (forgtting i's raction and that thr ar sticky prics) inducs a currnt dprciation of th domstic currncy, so th nominal xchang rat incrass. i LM 0 LM 1 i* BP IS 0 Y Y

9 dr Bartłomij Rokicki Opn Economy Macroconomics Th impact of montary xpansion in a short-run (2) Givn th intrst rat parity ( i= i *+ ), th fall in i Δ < 0, i.. it must b associatd with an xpctd futur apprciation. In ordr to gnrat an xpctd apprciation, th currncy ovrdprciats (i.. ovrshoots) vs. it's long-run lvl. Th currncy dprciation, togthr with ΔP = 0 in th short-run, implis that q riss, and IS shifts to th right. Th shifts in IS and LM shift aggrgat dmand, which quals shortrun aggrgat supply. Thr is an incras in output producd. i LM 0 LM 1 i* BP IS 1 IS 0 Y Y

10 dr Bartłomij Rokicki Opn Economy Macroconomics Th impact of montary xpansion - transition to th long-run Excss aggrgat dmand pushs up prics. Th incrasd pric lvl rducs ral mony supply so th LM shifts back to its initial quilibrium. Th intrst rat riss to its initial position, and as this happns th domstic currncy apprciats ( falls). Th incras in prics, togthr with th currncy apprciation, rducs th domstic conomy's comptitiv advantag in th goods markt, and IS shifts back to its initial position. W rturn to th initial ral quilibrium with: o Incrasd prics o A nominal xchang rat dprciation o Th ral xchang rat at its initial lvl i LM 0 LM 1 i* BP IS 1 IS 0 Y Y

11 dr Bartłomij Rokicki Graphical analysis using th IRP modl Opn Economy Macroconomics RET h W start in a long-trm quilibrium with givn M, P, Y, i and. * RET ( E 1, i*) i 1 i f M P 1 1 L(Y, i) ral mony stock

12 dr Bartłomij Rokicki Graphical analysis using th IRP modl (2) Opn Economy Macroconomics Expansionary montary policy shifts th ral mony supply curv downwards. As a rsult thr is a fall in domstic nominal intrst rat and th RET h curv shifts to th lft. Furthrmor, du to chang in montary policy, an xpctd xchang rat incrass so RET f curv shifts upwards. Hnc, th nominal xchang rat incrass from 1 to 2. M P RET h 2 1 RET ( 2, i *) M P 2 RET f ( 1, i *) i i 2 i 1 L (Y, i) f ral mony stock

13 dr Bartłomij Rokicki Graphical analysis using th IRP modl (3) Opn Economy Macroconomics An incras in production abov its long-run lvl lads to an incras in prics. So, ral mony supply will fall to its initial lvl (in a long trm P incrass proportionally to M). This lads to an incras in nominal intrst rat and shifts th RET h curv to th right. Hnc, th nominal xchang rat falls from 2 to 3. In nw long-trm quilibrium w hav highr P, M and. Production and i rmain constant. M P M RET h RET ( 2, i *) 2 P i 2 i 1 L (Y, i) ral mony stock RET f f ( 1, i *) i

14 dr Bartłomij Rokicki Opn Economy Macroconomics Conclusions A prmannt incras in a country s mony supply causs a proportional long run dprciation of its currncy. Howvr, th dynamics of th modl prdict a larg dprciation first and a smallr subsqunt apprciation. A prmannt dcras in a country s mony supply causs a proportional long run apprciation of its currncy. Howvr, th dynamics of th modl prdict a larg apprciation first and a smallr subsqunt dprciation. Exchang rat ovrshooting hlps xplain why xchang rats ar so volatil. Ovrshooting occurs in th modl bcaus prics do not adjust quickly, but xpctations about prics do.

15 dr Bartłomij Rokicki Opn Economy Macroconomics r LM 0 LM 1 r* BP IS 1 IS 0 Y 0 Y 1 Y

16 dr Bartłomij Rokicki Opn Economy Macroconomics Qustion1. Answr th following qustions applying th Dornbusch modl of ovrshooting xchang rats. a) In th litratur, Dornbusch s modl is rfrrd to as an xchang rat ovrshooting modl. Why is it rfrrd to in this way? What is th bhavioral logic that undrpins th modl and its prdictions? b) Considr an xpansion of th domstic mony supply whn th systm is in quilibrium. Show what ffct this will hav on th intrst rat, domstic prics, and th xchang rat. c) Suppos you wr an advisor to a group of agricultural xportrs. On th basis of th Dornbusch modl would you advis thm to lobby for tight or loos montary policy? Why?

17 dr Bartłomij Rokicki Opn Economy Macroconomics Qustion 2. Suppos that th govrnmnt of a small opn conomy, du to high inflation, dcids to prmanntly dcras mony supply. Applying th Dornbusch modl xplain what will b th impact of such a policy on nominal and ral xchang rat in a short and a long run. Analyz th volution of ral mony supply, prics and intrst rats. Rcall th assumptions of th modl that lad to such rsults. Th answr should includ th ncssary diagrams. Qustion 3. Lt s assum that th dmand for domstically producd output is also a function of an xognous componnt, G (you can think of it as a public spnding componnt). Imagin that th govrnmnt incras prmanntly public spnding from G = 0 to G = G. Dos th quilibrium valu of th ral xchang rat and th nominal xchang rat chang? Dos th nominal xchang rat ovrshoot its long-run valu?

18 dr Bartłomij Rokicki Opn Economy Macroconomics Qustion 4. Considr th simplifid vrsion of th Dornbusch modl whr prics ar fixd in th first priod and prfctly flxibl from priod 2 onwards. Driv th rspons of th nominal and ral xchang rats to th following shocks: (a) a prmannt incras in th rat of mony growth; (b) a prmannt incras in th full mploymnt output lvl. Distinguish btwn th cas in which th lasticity of dsird xpnditur to th ral xchang rat (h) is: (i) qual to on; (ii) lss than on. Qustion 5. Considr th Dornbusch modl as prsntd abov and dscrib th adjustmnt mchanism in th following xprimnts. a) suppos that y, th long-run lvl of output, incrass to y 1. Do you xpct to obsrv ovrshooting in th nominal xchang rat? b) suppos now that th snsitivity of markt xpctations to ovr- or undrvaluation of th currncy rlativ to th quilibrium xchang rat, incrass. Dscrib th adjustmnt mchanism following this unxpctd chang. c) Dscrib th adjustmnt path of th conomy following a chang in th intrst rat lasticity of mony dmand.