Chartered Financial Analyst (CFA) Practice Exam Level 2

Which of the following best describes the Dornbusch Overshooting Model?

1. It focuses solely on long-term price adjustments

2. It explains exchange rate dynamics and short run policy responses

3. It predicts the stability of currency values

4. It ignores sticky prices in exchange rates

The correct answer is: It explains exchange rate dynamics and short run policy responses

The Dornbusch Overshooting Model is primarily centered on the dynamics of exchange rates and how they react to changes in monetary policy and economic conditions in the short run. The model suggests that due to sticky prices in the short term, exchange rates can deviate significantly from their long-term equilibrium values as markets adjust to new information. In this model, when there is a change in monetary policy, such as an increase in the money supply, the immediate effect is a depreciation of the currency due to higher inflation expectations. However, due to the stickiness of prices, this depreciation may overshoot the level that would be expected at equilibrium, leading to excessive fluctuations in currency value before stabilizing eventually at a new long-term equilibrium. This behavior highlights the complexity of exchange rate adjustments and illustrates how short-run responses can be significant in the context of economic policy. Other descriptions, such as focusing solely on long-term price adjustments, do not capture the essence of the model, which emphasizes the short-run dynamics that can lead to overshooting. Similarly, predicting the stability of currency values or ignoring sticky prices would miss critical components of the model's application and implications in real-world scenarios. Therefore, the characterization that it explains exchange rate dynamics and short run policy responses accurately captures