A Dynamic Model of the Open Economy with Sluggish Output

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A Dynamic Model of the Open Economy with Sluggish Output

Kiguel and Dauhajre, 1988.

Under a flexible exchange rate system, large fluctuations in the nominal and the real exchange rates seem to be the rule rather than the exception. The significant appreciation of the dollar during the early 1980's followed by its recent steep depreciation provides new evidence for this fact. The seminal work of Dornbusch (1976) introduces the notion that exchange rates are likely to be very volatile in the presence of sticky prices, a fixed level of output, and continuous adjustment in the asset markets. As a matter of fact, the assumption of instantaneous adjustment in the asset markets and the existence of sticky prices were central to overshooting the exchange rate in Dornbusch's framework.