"Dornbusch's model" is the right answer to our latest quiz*. Congratulations, Pedro! Here is the basic idea of Rüdiger Dornbusch's seminal paper[1]:

Two relationships lie at the heart of the overshooting result. The first, equation (1) below, is the uncovered interest parity condition. It says that the home interest rate on bonds, i, must equal the (exogenously given) foreign interest rate i*, plus the expected rate of change of the exchange rate, E_t (e_t+1 - e_t), where e is the logarithm of the exchange rate (price notation, increase represents a depreciation of home currency).The second core equation of the Dornbusch model is the money market equilibrium condition.The demand for (log) real money balances (m - p) is assumed to depend negatively on the domestic interest rate (higher interest rates raise the opportunity cost of holding money) and positively on (log) real income (increase in output raises the transactions demand for money) and will, in equilibrium, equal the real money supply.

By combining equation (1) and (2) with a few simple assumptions one can easily see how "overshooting" works[2]: "First, assume that the domestic price level p does not move instantaneously in response to unanticipated monetary disturbances, but adjusts only slowly over time. Second, assume that output y is exogenous (what really matters is that it, too, moves sluggishly in response to monetary shocks). Third, we will assume that money is neutral in the long run, so that a permanent rise in m leads a proportionate rise in e and p, in the long run.

Now suppose, following Dornbusch's famous thought experiment, that there is an unanticipated permanent increase in the money supply m. If the nominal money supply rises but the price level is temporarily fixed, then the supply of real balances m-p must rise as well. To equilibrate the system, the demand for real balances must rise. Since output y is assumed fixed in the short run, the only way that the demand for real balances can go up is if the interest rate i on domestic currency bonds falls. According to equation (1), it is possible for i to fall if and only if, over the future life of the bond contract, the home currency is expected to appreciate. But how is this possible if we know that the long run impact of the money supply shock must be a proportionate depreciation in the exchange rate? Dornbusch's brilliant answer is that the initial depreciation of the exchange rate must, on impact, be larger than the long-run depreciation. This initial excess depreciation leaves room for the ensuing appreciation needed to simultaneously clear the bond and money markets. The exchange rate must overshoot. Note that this whole result is driven by the assumed rigidity of domestic prices p. Otherwise, as the reader may check, e, p, and m would all move proportionately on impact, and there would be no overshooting."

Here is the figure Dornbusch came up with[1]:At point A, the economy is in initial full employment equilibrium. The asset-market equilibrium schedule QQ that combines monetary equilibrium (equation 2) and bond market equilibrium (equation 1) is drawn for the initial quantity of money. After a monetary expansion the asset-market equilibrium schedule will shift out to Q'Q'. Under the assumption that asset markets always clear and that prices are sticky we obviously jump to point B. After a while we reach point C where not only the asset market but also the goods market clear (the goods market equilibrium schedule is positively sloped and flatter than a 45° line. The goods market equilibrium curve/"zero inflation"-curve goes first through point A and after the monetary expansion through point C.

*first line: long run effect, second line: short run effect, third line: variables (interest rate, price level, exchange rate). Pie charts represent clocks (shaded area depicts how much time has already elapsed). Image: mexp.gif

[1] Expectations and Exchange Rate Dynamics, Rüdiger Dornbusch, The Journal of Political Economy, Vol. 84, No. 6. (Dec., 1976), pp. 1161-1176.
[2] Dornbusch's Overshooting Model After Twenty-Five Years (Mundell-Fleming Lecture), Kenneth Rogoff