Dornbusch Model

Mundell-Fleming model

- small open economy
- dynamic model
- sticky prices (prices adjust over time in the DB model)
- rational expectations as an extension of the MF model

Demand for domestic goods: $Z \equiv C(Y-T) + I(Y,r) + G + X - QIM$

- C (consumption) is increasing in Y-T (disposable income)
– I (investment) is increasing in Y (production) and decreasing in r (real interest rate)
– G is government spending
– X is export
– QIM (Q: real exchange rate) is the value of import in terms
of domestic goods

Net exports$NX = X(Y*,Q) - QIM(Y,Q)$

– X (export) is increasing in Y* and Q
– IM (import) is increasing in Y and decreasing in Q
– Q affects NX through three channels

Real depreciation leads to an increase in net exports

- Takes time for the quantity of imports and exports to adjust
- NX initially declines
- Over time, exports increase and imports falls
- NX eventually exceeds the level before depreciation

- Dynamic model with sticky prices and rational expectations
- Suggests that exchange rate volatility could be driven by instability in the monetary policy

- Small open economy (foreign interest rate, i*, is exogenous)
- Output is determined by demand
- Perfect capital mobility
- Sticky prices (takes time to adjust)
- Rational expectations (perfect foresight when there's no random shocks)