Gradual Output Adjustment and Expansionary Monetary Policy

Examines the effects of a monetary expansion on certain key macroeconomic variables, in particular the nominal exchange rate,competitiveness, and domestic output and employment, using a modified version of the Dornbusch (Journal of Political Economy, 1976)model. Dornbusch′s original analysis of the implications of sticky prices was conducted on the basis of two alternative assumptions concerning the supply side of the economy, a fixed (full‐employment)level of output and (in his Appendix) continuous goods market clearing,maintained by instantaneous output adjustment. Neither of these assumptions appears particularly satisfactory and the model presented here attempts to address the issue by assuming output to be instantaneously fixed, but to respond gradually to excess demand or supply in the goods market. The structure of the resulting model is such as to imply a third‐order dynamic adjustment process which is solved explicitly. Two principal conclusions follow from the analysis. First,despite the fact that the monetary expansion inevitably reduces the domestic interest rate, nominal exchange rate overshooting need not result. Second, the dynamics of adjustment are considerably more complicated than in the original Dornbusch model and may, in fact, be cyclical in nature.