The Dynamics of Money Supply Exchange Rate and Price in Ethiopia using Dornbusch Overshooting Models of Exchange Rate Determination
Determination of exchange rate doesn’t follow predicted and usual pattern. However, many attempts have been done to forecast its behavior both in the short run and long run as much as possible. This study examines the dynamics of money supply, price and exchange rate using Dornbusch overshooting models of exchange rate determination caused by price rigidities in the short run. Dornbusch’s small country assumption, perfect capital mobility and aggregate demand is an imperfect substitute of import have been incorporated which creates the possibility of exchange rate overshooting. In response to unanticipated positive monetary shock, interest rate decreases and exchange rate overshoot its long run equilibrium. This research explains the dynamics of intuitive exchange rate overshooting. Apart from the theoretical formations of exchange rate over shooting, this research also analyses Ethiopian data for exchange rate over shooting, delayed overshooting or no overshooting at all in response to unanticipated monetary shock. Quarterly data of twenty-five years for exchange rate, price, domestic nominal interest rate, real output, money supply and World interest rate have been taken and autoregressive distributed lag model (ARDL) has been used to detect the dynamics of macroeconomic fundamentals and exchange rate. Evidence of exchange rate overshooting in response to unanticipated money supply shock was found. The findings show that there exists long run equilibrium relationship between the exchange rate and the differentials of macroeconomic fundamentals. The implication is that macroeconomic fundamentals are significant in determining the exchange rate fluctuations in the long run. This finding is consistent with the Dornbusch overshooting and monetary models of exchange rate determination, which asserts that there is a long-run relationship between the exchange rate and macroeconomic fundamentals.
Key words - Exchange rate overshooting, Exchange rates, monetary model, Autoregressive distributed lag (ARDL), Cointegration and dynamics macroeconomic fundamentals.