Sir in Dornbusch model it is stated that the prices are sticky and hence the exchange rate will overshoot and then gets back to the equilibrium. I’m not exactly able to undertake the meaning of that statement ‘prices are sticky, hence exchange rate overshoots’. what exactly does this mean?
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There are two types of goods in the economy – tradeable and non tradeable. Tradeable goods are those whose international prices are available. So, because of Inflation, when money supply rises, the price of tradeable goods rises but the price of non-tradeable goods are sticky, i.e, they increase with a lag.
When money supply rises, Interest rate should fall, but it should fall from say A to B (i.e, less) but it actually falls to C (i.e, more), i.e, it overshoots.
After a while, when the price of non-tradeable goods goes up, then the exchange rate comes back to B (the point where it should have fallen in the first place, that is, the equilibrium level)