What Is Overshooting?

In economics, overshooting, also known as the exchange rate overshooting hypothesis, is a way to think about and explain high levels of volatility in currency exchange rates using the concept of 澳洲幸运5官方开奖结果体彩网:price stickiness.

Understanding Overshooting

Overshooting was introduced to the world by Rüdiger Dornbusch, a renowned German 澳洲幸运5官方开奖结果体彩网:economist focusing on international economics, including monetary policy, macroeconomic development, growth, and international trade. Dornbusch first introduced the model, now widely known as the Dornbusch Overshooting Model, in the famous paper "Expectations and Exchange Rate Dynamics," which was published in 1976 in the Journal of Political Economy.

Before Dornbusch, economists generally believed that markets should, ideally, arrive at 澳洲幸运5官方开奖结果体彩网:equilibrium and stay there. Some economists had argued that volatility was purely the result of 澳洲幸运5官方开奖结果体彩网:speculators and inefficiencies in the 澳洲幸运5官方开奖结果体彩网:foreign exchange market, such as asymmetric inf🌄ormation or adju🎃stment obstacles.

Dornbusch rejected this view. Instead, he argued that 澳洲幸运5官方开奖结果体彩网:volatility was more fundamental to the market th𝓰an this, much closer to inherent in the market than to being simply and exc💖lusively the result of inefficiencies. More basically, Dornbusch was arguing that in the short run, equilibrium is reached in the financial markets, and in the long run, the price of goods responds to these changes in the financial markets. 

The Overshooting Model

The overshooting model argues that the foreign exchange rate will temporarily overreact to changes in monetary policy to compensate for sticky prices of goods in the economy. This means that, in the short run, the equilibrium level will be reached through shifts in 澳洲幸运5官方开奖结果体彩网:financial market prices, rather than through shifts in the prices of goods themselves. Gradually, as the prices of goods unstick and adjust to the reality of these financial market prices, thღe financial market, including the foreign exchange market, also adjusts to this financial real🌜ity.

So, initially, foreign exchange markets overreact to changes in monetary policy, which creates equilibrium in the short term. Then, as the prices of goods gradually respond to these financial market prices, the foreign exchange markets temper their reaction and create long-term equilibrium. Thus, there will be more volatility in the exchange rate due to overshooting and subsequent 澳洲幸运5官方开奖结果体彩网:corrections than would otherwise be expected. 

Special Considerations

Although Dornbusch's model was compelling, initially it was also regarded as somewhat radical due to its assumption of sticky prices. Today, sticky prices are accepted as fitting with empirical economic observations, and Dornbusch's Overshooting Model is widely regarded as the forerunner to modern international economics. In fact, some have said it "marks the birth of modern international macroeconomics."

The overshooting model is considered especially significant because it explained exchange rate volatility during a time when the world was moving from fixed to 澳洲幸运5官方开奖结果体彩网:floating rate exchanges. Kenneth Rogoff, during his stint as economic counselor and director of the research department at the 澳洲幸运5官方开奖结果体彩网:International Monetary Fund (IMF), said Dornbusch's paper imposed "rational expectations" on private actors about exchange rates. "Rational expectations is a way of imposing overall consistency on one's theoretical analysis," Rogoff wrote on the paper's 25th anniversary.

The Bottom Line

The overshooting model was introduced by economist Rüdiger Dornbusch to explain why exchange rates tend to be so volatile. This📖 theory states that exchang꧃e rates will react strongly to changes in monetary policy until goods prices reach a new equilibrium.