## Dornbusch's Overshooting Model After Twenty-Five Years, The Mundell-Fleming Lecture by Kenneth Rogoff, Economic Counselor and Director of the IMF Research Department

_IMF News, November 29, 2001_

## Source details

**Canonical URL:** [Dornbusch's Overshooting Model After Twenty-Five Years, The Mundell-Fleming Lecture by Kenneth Rogoff, Economic Counselor and Director of the IMF Research Department](https://www.imf.org/en/news/articles/2015/09/28/04/53/sp112901)

## Other formats

- [Markdown version](/en/news/articles/2015/09/28/04/53/sp112901/index.md)
- [Structured JSON version](/en/news/articles/2015/09/28/04/53/sp112901/index.json)
- [Bundle manifest](/en/news/articles/2015/09/28/04/53/sp112901/bundle-manifest.json)

## Bibliographic details
- Published: November 29, 2001

---

### Introduction
- Lecture given at the Second Annual IMF Research Conference, Washington, D.C., November 29-30, 2001; Mundell-Fleming Lecture delivered November 30, 2001 (revised January 22, 2002).
- Purpose: (1) convey why Dornbusch's "Expectations and Exchange Rate Dynamics" (Journal of Political Economy, 1976) has been so influential; (2) discuss empirical evidence for and against the model and sketch the model; (3) touch on competing notions of overshooting.

### Why Dornbusch (1976) Matters
- Characterized as "elegant" and "path breaking"; revived and reformed the Mundell-Fleming framework by incorporating sticky prices with rational expectations.
- Practical relevance: remains a quick policy tool for assessing monetary policy effects on exchange rates; applied beyond exchange rates to issues such as "Dutch disease," exchange rate regimes, commodity price volatility, and disinflation in developing countries.
- Conceptual insight: highlights interaction of sluggish goods markets with fast-clearing asset markets — a core idea retained in modern international macroeconomics.

### Empirical Influence and Pedagogical Reach
- Citation and teaching measures (1976–2001):
  - 917 published articles citing Dornbusch (1976) in the social science citation index (major economics journals).
  - 42 separate articles in International Monetary Fund Staff Papers cite Dornbusch (1976).
  - Roughly 40 percent of the issues of Staff Papers published between 1977 and 2001 included at least one article citing the Dornbusch model.
  - Peak citation years 1984-86: article received over 50 citations per year.
  - Late 1990s: still receiving over 25 citations per year.
- Popular and policy salience:
  - Economist magazine: 14 articles including "overshooting" and "exchange rates" during 1999-2000.
  - Financial Times: eleven references to overshooting during 2001.
  - Cited in speeches by prominent central bankers (examples in 2001: Alan Greenspan in June 2001; Jean-Claude Trichet in May 2001).
- Teaching: Dornbusch (1976) appears on virtually every advanced international finance course reading list surveyed.

### The Basic Overshooting Mechanism (Model Intuition)
- Core relationships:
  - Uncovered interest parity: domestic nominal interest rate i equals foreign interest rate i* plus expected rate of depreciation Et (et+1 - et); e is log of exchange rate (home currency price of foreign currency).
  - Money demand: real money balances depend on money supply m, price level p, and output y (logarithms), with interest sensitivity lowering money demand and output raising transactions demand.
- Key assumptions driving overshooting:
  - Domestic price level p is sticky (does not move instantaneously).
  - Output y is exogenous in the short run (or adjusts sluggishly).
  - Money is neutral in the long run: a permanent rise in m leads to a proportionate rise in e and p.
- Thought experiment:
  - A one-time unanticipated permanent increase in m with p fixed raises real balances m - p.
  - To equilibrate money market, domestic interest rate i must fall.
  - By uncovered interest parity, expected future appreciation is required; because long-run effect is proportional depreciation, initial nominal exchange rate depreciation must exceed the long-run depreciation — hence overshooting.

### Theory: Formal Structure and Dynamics
- Rational expectations introduced to international macroeconomics: expectations must be model-consistent.
- Aggregate demand relates negatively to the real exchange rate; price adjustment follows a forward-looking sticky-price rule (Mussa-style).
- Dynamic system reduces to two simultaneous difference equations for the real exchange rate and price adjustment, producing saddle-path stability under typical parameter values (< 1 in Rogoff's exposition).
- Graphical solution: initial post-shock exchange rate lies at intersection of 45-degree line and saddle-path; initial nominal depreciation exceeds long-run depreciation (overshooting).

### Empirics: Evidence For and Against Overshooting
- Broad empirical consensus: difficulty systematically explaining short-run exchange rate movements for major currencies (Meese and Rogoff, 1983; Rogoff, 2001).
- Model performance:
  - Captures major turning points in monetary policy (examples cited: Volcker-era U.S. deflation, Thatcher-era U.K. deflation).
  - Less successful at explaining many other large exchange rate swings.
- Frankel (1979) generalization: under assumptions where monetary shocks predominate, generalized Dornbusch predicts a positive correlation between the real exchange rate and the real interest differential (high real interest rates bid up the real exchange rate).
- Forward vs. spot comovement:
  - Flood (1981) prediction: spot should move by more than forward in a one-time unanticipated money supply change; empirical series for yen/dollar and mark/dollar show movements in spot and forward series that are almost indistinguishable, with forward rate volatility slightly lower than spot volatility in sample — differences small.
- Caveats and refinements:
  - Empirical testing requires handling endogenous money supply, interest rates, real shocks, and alternative shock processes.
  - Model may describe major monetary regime shifts but not all short-run volatility.
  - Modern versions: when output is endogenous or money demand depends on consumption, overshooting need not occur.

### Undershooting and Parameter Sensitivity
- Parameter regimes matter:
  - Rogoff presents case with parameter < 1 producing upward-sloping saddle-path and overshooting.
  - If parameter > 1 (money demand sensitive to output and aggregate demand sensitive to real exchange rate), saddle-path can be downward sloping and the model can predict undershooting.
- Modern models with money demand dependent on consumption make undershooting more plausible.

### Competing and Complementary Overshooting Mechanisms
- Alternative approaches contemporaneous with Dornbusch:
  - Kouri (1976) and Calvo and Rodriguez (1977): overshooting driven by slow adjustment of national wealth/current account dynamics rather than sticky prices.
  - These models emphasize wealth/current account channels and medium-term real exchange rate effects.
- Integration:
  - Dornbusch-type monetary sticky-price mechanisms mainly drive short-run dynamics.
  - Kouri/Calvo-Rodriguez wealth/current-account mechanisms can be central to long-run real exchange rate changes.
  - Unified frameworks (e.g., Obstfeld and Rogoff, 1995) can incorporate both channels.

### Lasting Contributions and Policy Relevance
- Main legacies:
  - Revitalized Mundell-Fleming framework and sustained its policy relevance for decades.
  - First mainstream marriage of sticky prices with rational expectations in international finance.
  - A model of notable theoretical simplicity and pedagogical clarity that continues to inform policy thinking.
- Policy takeaway:
  - Dornbusch (1976) remains a useful, intuitive benchmark for analyzing monetary policy impacts on exchange rates, especially around major regime shifts, while acknowledging empirical limitations and the need for richer modern specifications.

*Lecture: "Dornbusch's Overshooting Model After Twenty-Five Years," Kenneth Rogoff, Mundell-Fleming Lecture, Second Annual IMF Research Conference, November 30, 2001 (revised January 22, 2002).*

---

## Content in this bundle

- [112901pdf (PDF)](/-/media/websites/imf/imported/external/np/speeches/2001/kr/_112901pdf.pdf){rel="external" type="application/pdf"}
- [Figure1pdf (PDF)](/-/media/websites/imf/imported/external/np/speeches/2001/kr/_figure1pdf.pdf){rel="external" type="application/pdf"}
- [Figure2apdf (PDF)](/-/media/websites/imf/imported/external/np/speeches/2001/kr/_figure2apdf.pdf){rel="external" type="application/pdf"}
- [Figure2bpdf (PDF)](/-/media/websites/imf/imported/external/np/speeches/2001/kr/_figure2bpdf.pdf){rel="external" type="application/pdf"}
- [Figure2cpdf (PDF)](/-/media/websites/imf/imported/external/np/speeches/2001/kr/_figure2cpdf.pdf){rel="external" type="application/pdf"}
- [Figure3apdf (PDF)](/-/media/websites/imf/imported/external/np/speeches/2001/kr/_figure3apdf.pdf){rel="external" type="application/pdf"}
- [Figure3bpdf (PDF)](/-/media/websites/imf/imported/external/np/speeches/2001/kr/_figure3bpdf.pdf){rel="external" type="application/pdf"}
- [Figure4pdf (PDF)](/-/media/websites/imf/imported/external/np/speeches/2001/kr/_figure4pdf.pdf){rel="external" type="application/pdf"}
- [Figure5pdf (PDF)](/-/media/websites/imf/imported/external/np/speeches/2001/kr/_figure5pdf.pdf){rel="external" type="application/pdf"}
- [Figure6pdf (PDF)](/-/media/websites/imf/imported/external/np/speeches/2001/kr/_figure6pdf.pdf){rel="external" type="application/pdf"}
- [Figure7adpdf (PDF)](/-/media/websites/imf/imported/external/np/speeches/2001/kr/_figure7adpdf.pdf){rel="external" type="application/pdf"}
- [Figure7egpdf (PDF)](/-/media/websites/imf/imported/external/np/speeches/2001/kr/_figure7egpdf.pdf){rel="external" type="application/pdf"}
- [Table1pdf (PDF)](/-/media/websites/imf/imported/external/np/speeches/2001/kr/_table1pdf.pdf){rel="external" type="application/pdf"}
- [Table2pdf (PDF)](/-/media/websites/imf/imported/external/np/speeches/2001/kr/_table2pdf.pdf){rel="external" type="application/pdf"}

---

## References

- [Germany and the IMF](http://www.imf.org/external/country/DEU/index.htm)
- [United Kingdom and the IMF](http://www.imf.org/external/country/GBR/index.htm)
- [Japan and the IMF](http://www.imf.org/external/country/JPN/index.htm)
- [United States and the IMF](http://www.imf.org/external/country/USA/index.htm)
- [Speeches](https://www.imf.org/en/news/searchnews)
- [Kenneth S. Rogoff](https://www.imf.org/external/np/bio/eng/kr.htm)
- [Second Annual IMF Research Conference](https://www.imf.org/external/pubs/ft/staffp/2001/00-00/arc.htm)
- [PRESS CENTER](http://presscenter.imf.org/)
- [Maurice Obstfeld's superb inaugural Mundell-Fleming lecture from last year (IMF Staff Papers, Vol. 47, 2001)](https://www.imf.org/External/Pubs/FT/staffp/2000/00-00/arc.htm)
- [https://www.imf.org/en/home](https://www.imf.org/en/home)

_Source: https://www.imf.org/en/news/articles/2015/09/28/04/53/sp112901_