Quantifying the effects of expectation variability on economic dynamics: insights from the Dornbusch overshooting model

Abstract

The article applies the famous Dornbusch "overshooting" model to investigate the impact of different types of expectations on economic model stability. We tested the well-known Dornbusch model with discrete variables. Initially, we established a foundational model, employing simulations to illustrate the impact of each parameter within the model on the overall solution, starting from an initial value. Subsequently, we explored the influence of different expectation types on the stability of the steady state vector, considering simple, static, adaptive, and rational expectations (Muth-type rational expectation and perfect foresight). It was observed that static expectations and perfect foresight did not contribute to stability. In the case of simple, adaptive, and rational expectations, the stability conditions (parameter combinations) are the same as the stability conditions for the steady state vector of the baseline model. This condition is restricted to four parameters: two related to the interest rate, one to the foreign-domestic price level and one to the adjustment speed. We also run a simulation to show how the inclusion of each type of expectation leads to a change in the global solution of the model for a given initial value.