Overshooting Meets Inflation Targeting

Abstract

This paper revisits Dornbusch’s overshooting model; first, to discuss the conditions of overshooting and undershooting, extending the model to consider monetary policy rules and imperfect capital mobility. And second, to outline Dornbusch’s representation in the context of a simple dynamic neo-Keynesian model that can be used to analyze the impact of persistent changes in monetary policy, among other shocks. The model considers inflation targeting in a small open economy setup, which is characterized by imperfect competition and short-run price rigidity. The main findings of the paper are consistent with the original contribution where the exchange rate overshoots its long run equilibrium. We also show that flexible exchange rates dominate managed exchange rates in terms of output and inflation volatility in the presence of real shocks, while for nominal shocks the reverse is true.