PRESENTATION ON DORNBUSCH STICKY PRICE THEORY ( UNIT II FOREIGN EXCHANGE MANAGEMENT)

Presented By: Aniket Lakhe

Rdiger "Rudi" Dornbusch (June 8, 1942 July 25, 2002) was a German economist who worked for most of his career in the United States.

DORNBUSCH STICKY PRICE THEORY

The sticky price theory makes a more detailed study of interest rates differential. The sticky price model generates an upward sloping short run aggregate supply curve. This is because firms are rigid in changing prices in response to changes in the economy.

 Dornbusch developed this model back when many economists held the view that ideal markets should reach equilibrium and stay there. Volatility in a market, from this perspective, could only be a consequence of imperfect information or adjustment obstacles in that market. Dornbusch argued that volatility is in fact a far more fundamental property than that.

 His model assumes that, while the prices of goods are sticky (slow to adjust), the exchange rate adjusts instantaneously to any change in current financial market conditions. Yet the stickiness of goods prices causes evolution over time in the goods market, and due to market linkages this leads to evolution over time in the foreign exchange market equilibrium. This results in variability in the exchange rate even after a shock to that market has gone away hence the exchange rate volatility.

 The increase in money supply in the market ( due to changes in real interest rate differential) leads to depreciation in the value of the domestic currency.

ASSUMPTIONS OF THIS THEORY

The money supply is endogenous. i.e. it is positively related to the market interest rates.

PPP (purchase power parity)theory applies in the long run.

So the expected inflation differential changes have a role to play in the determination of interest rates.

TWO SECTION OF STICKY PRICE THEORY

Study of interest rates differential.

a) Increase in Money Supply --------- Depreciation of Domestic Currency.

b) Rise in Interest Rates ------- Increase in Money Supply (Loanable Funds)-------Depreciation of Domestic Currency. c) Rise in Interest Rates------- Greater Inflows of Capital-------- Appreciation of Domestic Currency.

 Study of inflation rates differential. a) Increase in Money Supply------ Price Rise ---------Lower Interest Rate-------- Lower Inflow of Capital ----- Depreciation of Domestic Currency.

CONCLUSION
The Dornbusch sticky price model - also called overshooting model - represents a major contribution to exchange rate theory in the sense that departures from purchasing power parity and volatile currency levels can be explained rationally.

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