A bit confused regarding the explanation of pure monetary model in the CAFI,
To rectify that problem, Dornbusch (1976) constructed a modified monetary model that assumes prices have limited flexibility in the short run but are fully flexible in the long run. The long-run flexibility of the price level ensures that any increase in the domestic money supply will give rise to a proportional increase in domestic prices and thus contribute to a depreciation of the domestic currency in the long run, which is consistent with the pure monetary model. If the domestic price level is assumed to be inflexible in the short run, however, the model implies that the exchange rate is likely to overshoot its long-run PPP path in the short run. With inflexible domestic prices in the short run, any increase in the nominal money supply results in a decline in the domestic interest rate. Assuming that capital is highly mobile, the decline in domestic interest rates will precipitate a capital outflow, which in the short run will cause the domestic currency to depreciate below its new long-run equilibrium level. In the long run, once domestic nominal interest rates rise, the currency will appreciate and move into line with the path predicted by the conventional monetary approach.
Are not the two bolded sentences contradicting to each other?
There are various economic theories… They all like to contradict each other. Or at least they have different reasons for explaining why certain things are the way they are.
It’s called the Dornbusch overshoot model for a reason, and no, those two statements are not contradictory.
Because the price level of goods in the economy is inflexible in the short-run, inflation does not set in when an abundance of easy money has been injected into the money supply. This means that nominal interest rates fall (more money in the system without increases in the price of goods), and, assuming high capital mobility, capital floods out of the system in search of higher yield. This causes the currency to depreciate to a greater extent than prescribed by the pure monetary model, which assumes that prices are flexible in the short run (which would result in inflation in an expansionary monetary environment). Inflation = higher nominal rates, and thus same extent of capital outflows due to low nominal yields would not occur.
Once prices come up and inflation sets in, nominal yields should rise and bring back demand for that currency’s obligations, which causes the country’s currency to appreciate some, but it still ultimately is at a level lower than before the expansionary monetary policy. So it depreciates too much initially, appreciates back some over long-run, but still ultimately ends up at a lower value.