What Is Overshooting?
Let me explain overshooting to you directly: in economics, it's also called the exchange rate overshooting hypothesis, and it's a framework for understanding why currency exchange rates show such high volatility, all tied to the idea of price stickiness.
Key Takeaways
You should know that the overshooting model connects sticky prices directly to volatile exchange rates. Its core idea is that goods prices in an economy don't react right away to shifts in foreign exchange rates. Instead, you see a chain reaction starting with impacts on financial markets, money markets, derivatives, and bond markets, which then eventually influence goods prices.
Understanding Overshooting
Overshooting was brought to us by Rüdiger Dornbusch, a key German economist who specialized in international economics, monetary policy, macroeconomic development, growth, and trade. He presented this model, now known as the Dornbusch Overshooting Model, in his 1976 paper 'Expectations and Exchange Rate Dynamics' in the Journal of Political Economy.
Before Dornbusch, economists typically thought markets should reach equilibrium and stay there. Some blamed volatility on speculators or market inefficiencies like asymmetric information or adjustment barriers. But I want you to see that Dornbusch pushed back on this; he argued volatility is more inherent to the market itself, not just from inefficiencies. Fundamentally, he said that in the short run, financial markets hit equilibrium, and in the long run, goods prices adjust to those financial changes.
Important Note on Price Stickiness
Remember, price stickiness means some prices move slowly in response to market changes. The overshoot model asserts that exchange rates react sharply to monetary policy, while goods prices remain sticky.
The Overshooting Model
Here's how the model works: it argues that foreign exchange rates temporarily overreact to monetary policy changes to make up for sticky goods prices in the economy. In the short run, equilibrium comes from shifts in financial market prices, not goods prices. Over time, as goods prices unstick and align with these financial realities, the financial markets, including forex, adjust accordingly.
So, forex markets initially overreact to monetary policy shifts, establishing short-term equilibrium. Then, as goods prices slowly respond, forex markets moderate their reaction for long-term equilibrium. This leads to more exchange rate volatility from overshooting and corrections than you'd otherwise expect.
Special Considerations
Dornbusch's model was seen as radical at first because of its sticky prices assumption, but today, sticky prices match real economic data, and the model is a cornerstone of modern international economics. Some even call it the birth of modern international macroeconomics.
It's particularly important because it explained exchange rate volatility during the global shift from fixed to floating rates. Kenneth Rogoff, while at the IMF, noted that Dornbusch's paper applied rational expectations to private actors on exchange rates, ensuring overall consistency in analysis, as he wrote on its 25th anniversary.
What Does 'Sticky' Mean in Economics?
In economics, stickiness describes how goods prices change more slowly than the supply and demand for them. This could be due to sellers avoiding frequent price changes to cut menu costs, or challenges in tracking real-time production cost shifts. The formal term is nominal rigidity.
What Is Overshooting in Economics?
Overshooting refers to how some prices overreact to supply and demand changes, unlike classical economics where prices settle at equilibrium. It explains why exchange rates are more volatile than goods prices.
What Causes Volatility in Exchange Rates?
According to the Dornbusch model, exchange rates are volatile because forex markets are highly sensitive to monetary policy changes, while goods prices react slowly. Thus, when policy shifts, exchange rates fluctuate until goods prices adjust to the new equilibrium.
The Bottom Line
To wrap this up, the overshooting model from Rüdiger Dornbusch explains the volatility in exchange rates: they react strongly to monetary policy changes until goods prices hit a new equilibrium.
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