Sticky Prices in Open Economy Models Quiz: Slow Adjustment

Price stickiness means that goods and services prices do not adjust immediately when economic conditions change. Firms may face adjustment costs, long-term contracts, or menu costs that prevent instant repricing. As a result, when a monetary or demand shock hits, prices adjust gradually over weeks or months rather than instantly. This slow adjustment is a central feature of Keynesian and New Keynesian macroeconomic frameworks, including the Dornbusch model for open economies.

The answer is True. When prices are sticky, a monetary expansion raises nominal demand but prices cannot rise immediately to absorb the shock. Real output therefore increases in the short run, as firms supply more at the prevailing price level. In the open economy, the exchange rate also overshoots its long-run value. These real effects are larger and more persistent with sticky prices than in flexible price models where all adjustment occurs instantly with no real output effect.

When goods prices are sticky, they cannot adjust immediately to absorb a monetary shock. The money market must still clear, which requires an immediate adjustment in the interest rate. The interest rate change then triggers capital flows that move the exchange rate. Since goods prices cannot share the adjustment burden in the short run, the exchange rate must move more than it would in a world of fully flexible prices, producing the overshooting that is the central result of the Dornbusch model.

In flexible price models, any change in nominal variables such as the money supply is immediately and fully reflected in proportional price level changes, leaving real output, real interest rates, and real exchange rates unchanged. In sticky price models, prices lag behind and monetary shocks temporarily affect real variables. This distinction is critical because the Dornbusch model relies on sticky goods prices to explain why exchange rates overshoot and why monetary policy has real short-run effects in open economies.

Goods prices are sticky in practice due to long-term contracts that lock in prices, menu costs that make constant repricing costly for firms, and wage and price rigidities embedded in labor contracts and social norms. Government-mandated price controls in all sectors is not a general explanation for price stickiness; most economies have price controls only in specific sectors, not universally, so this cannot explain the broad phenomenon of sticky goods prices.

The answer is False. The real exchange rate changes significantly in the short run in the Dornbusch model, even though goods prices are sticky. The nominal exchange rate overshoots its long-run value immediately, while domestic prices remain temporarily unchanged. Since the real exchange rate equals the nominal rate adjusted for relative prices, and the nominal rate moves while prices do not, the real exchange rate changes substantially in the short run. It only returns to its long-run value as goods prices gradually adjust.

Purchasing power parity theory assumes that the exchange rate instantly adjusts to reflect differences in price levels across countries. The Dornbusch model rejects this for the short run by assuming goods prices adjust slowly. In the short run, prices are fixed, so the exchange rate can deviate substantially from the PPP value. Only in the long run, when prices have fully adjusted, does the exchange rate converge to the value implied by purchasing power parity.

When wages are also sticky alongside goods prices, the speed of overall goods price adjustment is slowed further because labor costs are a major component of production costs. Slower goods price adjustment means the exchange rate must remain at or near its overshooting value for longer, extending the period of deviation from long-run equilibrium. The combined stickiness of wages and goods prices prolongs the adjustment process and can amplify the real effects of monetary policy on output and competitiveness.

The answer is True. The Dornbusch model maintains the long-run neutrality of money. Even though goods prices are sticky in the short run, they do fully adjust over time. As they rise proportionally to the money supply increase, the real money supply, real interest rate, real exchange rate, and real output all return to their pre-shock levels. The only permanent change is in nominal variables: the price level and the nominal exchange rate are both permanently higher after a monetary expansion.

Sticky prices mean monetary policy has real short-run effects, the exchange rate overshoots because it bears the full short-run adjustment burden, and the current account responds more slowly because import and export prices are tied to sticky goods prices that change gradually. Sticky prices are precisely why purchasing power parity does not hold in the short run in the Dornbusch model; PPP holds only in the long run once prices have fully adjusted to the monetary shock.

The J-curve effect arises because when a currency depreciates, import and export prices change quickly but the quantities of imports and exports adjust only gradually, as firms and consumers need time to change their purchasing patterns. In the short run, the depreciation raises the domestic currency cost of imports more than it boosts export revenues, worsening the trade balance. Only over time, as quantities adjust, does the trade balance improve. This pattern is a consequence of sticky quantity adjustments in goods markets.

The answer is True. Empirical evidence consistently shows that goods and services prices adjust far more slowly than financial asset prices including exchange rates and interest rates. This difference in adjustment speeds is well documented in the macroeconomic literature and supports the key assumption underlying the Dornbusch model. The evidence helps explain why exchange rate volatility under floating regimes is so much higher than goods price volatility, consistent with the model's predictions.

In a flexible price model, a monetary expansion is immediately and fully absorbed by proportional price increases, leaving real output, real exchange rate, and real interest rates unchanged. In a sticky price model such as the Dornbusch framework, prices cannot adjust immediately, so monetary expansion temporarily raises real output, lowers the real interest rate, and causes the real exchange rate to overshoot. These short-run real effects are significant for policymakers and are the reason sticky price models are central to policy analysis.

The flexible price and sticky price models diverge in key ways following a monetary expansion. Exchange rate depreciation is larger in the short run in the Dornbusch model due to overshooting. Real output temporarily rises in the Dornbusch model but is unaffected in the flexible price model. Goods prices rise immediately in the flexible price model but adjust gradually in the Dornbusch model. The claim that both models produce identical outcomes is incorrect; this is precisely the distinction the Dornbusch model was designed to illustrate.

In the short run of the Dornbusch model, the nominal exchange rate overshoots while goods prices remain fixed. This means the real exchange rate, which reflects relative purchasing power, depreciates significantly. This temporary real depreciation improves export competitiveness and stimulates net exports. In the long run, goods prices rise proportionally with the money supply and the nominal exchange rate, so the real exchange rate returns to its original value, consistent with long-run monetary neutrality.