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From Dornbusch to Murphy: Stylized Monetary Dynamics of a contemporary Macroeconometric Model

Dornbusch's 1976 overshooting exchange rate model (hereafter, DBM) has long been known to underpin several large macro models, including the Murphy Model (MM). But the dynamic adjustment paths of variables in MM differ markedly from those in DBM, even qualitatively. A leading case in point is the exchange rate which in MM undershoots its new long run-equilibrium value after the injection of a monetary shock, and then actually moves away from this equi-librium for a time before approaching it via a damped cyclical adjustment path (whereas the corresponding path in DBM is monotonic). This paper gives a simplified account of how this comes about. The emphasis is not so much on theoretical rigour but on providing a convincing practical demonstration. Using the simplest form of DBM as a starting point, it is shown how one can develop a miniature model exhibiting an MM-like response to a monetary shock. The key idea is that aggregate demand does not respond instantaneously (as in DBM) to shocks in the macroeconomic environment, but shows some degree of inertia. Nothing more is required to reconcile the qualitative dynamics of MM with DBM.

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Paper provided by Victoria University, Centre of Policy Studies/IMPACT Centre in its series Centre of Policy Studies/IMPACT Centre Working Papers with number ip-69.

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Date of creation: Jan 1998
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Handle: RePEc:cop:wpaper:ip-69
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  1. Dornbusch, Rudiger, 1976. "Expectations and Exchange Rate Dynamics," Journal of Political Economy, University of Chicago Press, vol. 84(6), pages 1161-76, December.
  2. Murphy, C W, 1988. "An Overview of the Murphy Model," Australian Economic Papers, Wiley Blackwell, vol. 27(0), pages 175-99, Supplemen.
  3. John B. Taylor, 1995. "The Monetary Transmission Mechanism: An Empirical Framework," Journal of Economic Perspectives, American Economic Association, vol. 9(4), pages 11-26, Fall.
  4. David W.R. Gruen & Marianne C. Gizycki, 1993. "Explaining Forward Discount Bias: Is it Anchoring?," RBA Research Discussion Papers rdp9307, Reserve Bank of Australia.
  5. Murphy, C W, 1988. "Rational Expectations in Financial Markets and the Murphy Model," Australian Economic Papers, Wiley Blackwell, vol. 27(0), pages 61-88, Supplemen.
  6. Taylor, John B., 1993. "Discretion versus policy rules in practice," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 39(1), pages 195-214, December.
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