Short Run vs Long Run Exchange Rate Adjustment Quiz

The Dornbusch model is built on the difference between short-run and long-run adjustment. In the short run, goods prices are sticky and cannot change, so the exchange rate must do all the adjusting and overshoots its long-run value. In the long run, goods prices gradually rise to absorb the monetary shock, the real money supply contracts, interest rates normalize, and the nominal exchange rate appreciates back to a level consistent with purchasing power parity.

The answer is True. In the long run, the Dornbusch model respects the classical quantity theory and purchasing power parity. A permanent increase in the money supply raises the domestic price level proportionally, and since purchasing power parity holds in the long run, the nominal exchange rate depreciates by the same proportion. The long-run neutrality of money means all real variables including the real exchange rate return to their pre-shock values after prices have fully adjusted.

In the short run, the nominal exchange rate depreciates sharply beyond its long-run value while goods prices remain fixed, causing the real exchange rate to depreciate and improving international competitiveness. Over time, goods prices rise in line with the monetary expansion. As the price level and nominal exchange rate both increase proportionally, the real exchange rate returns to its original level. This path illustrates the short-run real effects and long-run nominal effects of a monetary shock.

After the initial overshooting, the economy moves along the saddle path. The exchange rate, having depreciated beyond its long-run value, gradually appreciates as goods prices slowly rise. The two variables adjust simultaneously and continuously until both reach their new long-run equilibrium values. The nominal exchange rate ends up permanently depreciated relative to its pre-shock level but below the overshooting value, and the price level ends up permanently higher, consistent with purchasing power parity.

In the short run of the Dornbusch model, the nominal exchange rate overshoots, goods prices are fixed so the exchange rate bears all adjustment, and capital outflows triggered by lower domestic interest rates drive the overshooting depreciation. The real exchange rate does not return immediately to its pre-shock level; it depreciates in the short run because the nominal rate falls while prices are fixed, only returning to its original value in the long run as prices catch up.

The answer is False. The Dornbusch model predicts that in the long run, the real interest rate returns to its original pre-shock level. The monetary expansion temporarily lowers the nominal and real interest rate in the short run. But as goods prices rise, the real money supply contracts back to equilibrium, the nominal interest rate rises back toward the world rate, and the real interest rate normalizes. Long-run monetary neutrality implies that no real variable including the real interest rate is permanently affected.

Following an exchange rate depreciation, import prices rise quickly in domestic currency terms while export and import quantities adjust slowly due to sticky contracts and habits. This can initially worsen the trade balance, the J-curve effect, before the volume of exports rises and imports falls as buyers and sellers respond to the new price signals. In the long run, as prices and quantities fully adjust, the current account improves, reflecting the full trade impact of the depreciation.

A monetary expansion immediately increases the money supply, pushing the nominal interest rate below the world rate in the short run as the money market clears at the lower rate. This lower rate triggers capital outflows and exchange rate overshooting. Over time, goods prices rise, the real money supply falls back to its original level, and the nominal interest rate gradually rises back to the world rate. In the long run, interest rate parity is restored at the world rate and the domestic rate returns to it.

The answer is True. The speed at which the exchange rate converges from its overshooting value back to long-run equilibrium depends entirely on the speed of goods price adjustment. Faster price adjustment means the real money supply contracts more quickly, interest rates normalize sooner, and the exchange rate can appreciate back to equilibrium faster. Slower or stickier prices extend the period of deviation from the long-run equilibrium, keeping the exchange rate near its overshooting level for longer.

In the long run of the Dornbusch model, the nominal exchange rate is permanently depreciated by the proportion of the money supply increase, consistent with purchasing power parity. The real exchange rate returns to its original level as prices rise fully. The domestic interest rate returns to the world rate as the real money supply normalizes. The claim that the nominal rate remains permanently at the overshooting value is incorrect; the overshooting is a temporary short-run phenomenon that corrects as prices adjust.

In the long run, goods market equilibrium requires that the economy return to its full employment output level and that the real exchange rate be consistent with balanced trade. This real exchange rate condition, combined with purchasing power parity, determines the long-run nominal exchange rate. The nominal exchange rate settles at the value that simultaneously satisfies the money market, goods market, and purchasing power parity conditions, providing the anchor around which the short-run overshooting converges.

The answer is False. In the standard Dornbusch model, the convergence of the exchange rate from overshooting to long-run equilibrium is driven entirely by goods price adjustment, not fiscal policy. Fiscal policy affects aggregate demand and can shift the IS curve, but it does not directly accelerate the goods price adjustment process that drives convergence. The speed of convergence is a function of how quickly the goods market clears and prices respond, which is a structural feature of the economy rather than a policy choice.

The Dornbusch model predicts large short-run deviations from purchasing power parity because the nominal exchange rate overshoots while goods prices are fixed, causing the real exchange rate to deviate from its equilibrium. These deviations are not random but follow a predictable path. As goods prices gradually adjust over the long run, the real exchange rate returns to its equilibrium level and purchasing power parity is restored, making deviations temporary and mean-reverting rather than permanent.

Key differences between short-run and long-run exchange rate dynamics include overshooting in the short run due to sticky prices, long-run monetary neutrality with the real exchange rate returning to its original value, and the J-curve pattern where the current account may initially worsen before improving as trade volumes adjust to the new exchange rate. The claim that short-run and long-run exchange rates are always identical contradicts the defining feature of the Dornbusch model.

Understanding the difference between short-run and long-run adjustment is critical for policymakers. A monetary expansion may be appropriate for long-run objectives, but the short-run overshooting it produces can cause sharp exchange rate volatility and J-curve trade balance deterioration. Policymakers who only focus on long-run equilibrium and ignore short-run dynamics risk being surprised by the immediate economic disruption that overshooting causes, including inflationary pressure from import price rises and currency market instability.