Sticky Price Theory Aniket

8/3/2019 Sticky Price Theory Aniket

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Presented By: Aniket Lakhe

PRESENTATION ON DORNBUSCHSTICKY PRICE THEORY

( UNIT II FOREIGN EXCHANGE

MANAGEMENT)


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Rdiger "Rudi"

Dornbusch (June 8,1942 July 25, 2002)

was a Germaneconomist who worked

for most of his career inthe United States.


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DORNBUSCH STICKY PRICE THEORY

The sticky price theory makes a more

detailed study of interest rates differential.

The sticky price model generates an upwardsloping short run aggregate supply curve.

This is because firms are rigid in changing

prices in response to changes in the

economy.


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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 aconsequence of imperfect information or

adjustment obstacles in that market.

Dornbusch argued that volatility is in fact a far

more fundamental property than that.


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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 ofgoods 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 theexchange rate even after a shock to that market has

gone away hence the exchange rate volatility.


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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.


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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 havea role to play in the determination of interest rates.


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TWO SECTION OF

STICKY PRICE THEORY

Study of interest rates differential.

a) Increase in Money Supply --------- Depreciationof Domestic Currency.

b) Rise in Interest Rates ------- Increase in MoneySupply (Loanable Funds)-------Depreciation ofDomestic Currency.

c) Rise in Interest Rates------- Greater Inflows ofCapital-------- Appreciation of DomesticCurrency.


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Study of inflation rates differential.

a) Increase in Money Supply------ Price Rise ----------

Lower Interest Rate-------- Lower Inflow of Capital ------ Depreciation of Domestic Currency.


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CONCLUSION

The Dornbusch sticky price model - also calledovershooting model - represents a major contribution toexchange rate theory in the sense that departures frompurchasing power parity and volatile currency levels can be

explained rationally.

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Sticky Price Theory Aniket

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