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Do exchange rate overshooting models make sense?
Not so much. Here is the overshooting model for those of you who don't know it.
So what is the problem? First, most observed exchange rate movements are unexpected ("news"), rather than forecast in earlier forward rates. The overshooting model, at best, explains expected movements in exchange rates.
Second, the model relies on a Keynesian money demand function. Specifically, inflation, operating through a portfolio effect, lowers nominal rates of interest in the initial stage of the mechanism. Well, sometimes, but don't count on it. More generally, the currency vs. interest-bearing assets decision doesn't have many implications for foreign exchange markets, if any.
Arnold Kling offers some further comments, including this bit:
But in the Dornbusch model, countries differ in terms of their inflation rates. Inflation is described mathematically as a continuous movement in prices ("Rudi Dornbusch is the master of the logarithmic derivative," as Rogoff used to put it.) The swindle, which is present in all modern macro, is to talk about sticky prices and continuously-moving prices in the same breath.
Exchange rates are not well understood. The current best theory is a mix of random walk (but in exchange rates or returns?), noise traders, and possibly some predictable, very long-run, PPP-reverting swings, enabled by the possibility that perhaps traders' time horizons are too short to compress all of the expected future into the present. But, unlike what the Dornbusch model predicts, these changes are not well-predicted by nominal interest rate differentials.
Here is a more favorable assessment of the model, from Ken Rogoff.
Posted by Tyler Cowen on November 21, 2007 at 07:42 AM in Economics | Permalink
Comments
The reference cited contains the following sentence.
"Although its empirical validity is questionable, UIP is a very useful tool for macroeconomic model building"
This is science?
Posted by: tom at Nov 21, 2007 11:53:48 AM
"The swindle, which is present in all modern macro, is to talk about sticky prices and continuously-moving prices in the same breath."
Macro may not be my thing, but that looks like a serious overstatement and major oversight on Kling's part.
A lot of international macro models, Dornbusch's included, discuss tradeable versus non-tradable goods and/or services. The tradeable goods flow freely around the world, the nontradable goods (like services) don't flow so much or so quickly. The classic example of a non tradebale good or service is haircuts. One might not expect haircuts to flow freely and instantaneously around the world in response to currency movements and relative prices. I believe that's what forces the overshooting in Dornbusch's model. The more non-tradeable goods you have, the more the exchange rate, which governs the relationship of tradeable good prices, has to overshoot.
This is based on some very vague recollection on my part, I confess.
Posted by: Keith at Nov 21, 2007 1:04:52 PM
Arnold's comment is even more off-base. Sticky prices do change smoothly. It is non-sticky
prices that change discontinuously, supposedly bouncing around with every single little unexpected
shock from either supply or demand, along with wages. This is the nonsense that lies behind the
inane claim that we are always on a vertical aggregate supply curve.
Rogoff does pretty well. All structural models are in deep doo doo empirically thanks to his
random walk result with Meese. But, there do seem to be (or have been) episodes that fit the
Dornbusch overshooting model, including the classic episode that initially inspired him, drawing
on the earlier work of Gustav Cassel, namely the far overshoot of the French franc downwards
against the dollar in the 1920s when its high inflaton rate exceeded that of the US's, although
not nearly by as much as the franc went down. This led to a wild non-PPP situation that favored
the dollar, peaking in 1925 when the rate reached 52 francs to the dollar (post-WW II average,
7 to 1). That period was when it was very easy to be a very poor US expat writer or artist
hanging about in Paris, playing Lost Generation and all that, which many did very famously.
Posted by: Barkley Rosser at Nov 21, 2007 4:24:18 PM
To add to the above, calling it a 'swindle' is definitely too much, though it can be an annoyance when teaching it to undergrads - having a model both with fixed (not sticky) prices and inflation. But you can set it up with Calvo price setting, Fisher or Taylor staggered price setting or what have you and you get the same result. But usually you don't expect econ undergrads to be able to solve 2nd (or higher) order difference equations or learn the method of undetermined coefficients or what have you. So you wave some hands and pretend that there's a period called 'short run' when prices are fixed and a period called 'long run' when there's inflation. It's not a swindle, it's a modeling convention that makes things easier to explain.
I'm with Rogoff on this too.
Tom, what the statement probably means, is that by itself UIP is not well supported empirically. But if you build on it, add in some risk premiums, some noise traders, etc. - i.e. expand the model to make it more realistic then you do a lot better.
Posted by: notsneaky at Nov 21, 2007 8:24:42 PM
notsneaky,
Staggeredly sticky prices are sufficient to get the result, although
indeed messier to derive than fixed prices.
Posted by: Barkley Rosser at Nov 22, 2007 2:56:57 PM
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