Hello,
I was wondering with the Dornbush overshooting model, they say that the currency values overshoot the long run implied PPP values.
Does that mean that prices are constant in the short term and then both the currency value and price readjust to meet their long term values in order to comply with the long term PPP?
Thanks,
The theory that exchange rates are driven (also) by the relative PPP of currencies say that exchange rates should move when prices move in order to prevent arbitrage (export goods to the more expensive country and get a profit in the exchange rate until the gap disappears). This is partially true in the long term, but not in the short term. The reasons are obvious… it is difficult to export / import in the short term, so the adjustment is in the long term.
What if exchange rates are impacted exogenously? 1/ Must prices move in the short term?
The answer is No, prices are sticky in the short term. So the adjustment of prices because movements of exchange rates is also in the middle to long terms.
1/ Exogenous, contrary to endogenous, means something / a force that comes from external sources.