From Dornbusch to Murphy: Stylized Monetary Dynamics of a Contemporary Macroeconometric Model

Newer applied macroeconometric models have adopted a mixture of paradigms to capture at least the major differences between the behavior of financial markets and markets for commodities and for factors. Thus, in the Murphy Model of the Australian macroeconomy (MM), rational expectations and very rapid adjustment are assumed to apply in markets for financial assets, but frictions and departures from rationality manifest themselves in the short-term behavior of other markets. A popular story for the reaction of exchange and interest rates to monetary shocks is provided by Dornbusch’s 1976 overshooting exchange rate model (DBM). The rational-expectations version of this archetypal model underpins MM, yet the dynamic adjustment paths of variables in MM differ markedly from those in DBM. A leading case in point is the exchange rate which in MM actually undershoots its new equilibrium value after the injection of a monetary shock. This paper gives a simplified account of how the differences come about. The emphasis is not so much on theoretical rigor as on providing a convincing practical demonstration. Using the simplest form of DBM as a starting point, it is shown how one can progressively develop a miniature model exhibiting an MM-like response to a monetary shock. The key idea in this development is that aggregate demand does not respond instantaneously to shocks in the macroeconomic environment. The vehicle used to implement the numerical miniature model is a computer spreadsheet. Although the specifics relate to MM, the generics of this development seem likely to be applicable to most models adopting the mixture of paradigms identified above. This conclusion survives the current proclivity to replace Dornbusch’s money demand function in the larger models by a policy reaction function in which interest rates are manipulated to control inflation.  2000 Society for Policy Modeling. Published by Elsevier Science Inc.