Overshooting model

Overview

The overshooting model is a concept in international finance and macroeconomics that explains why exchange rates can be more volatile than the underlying economic fundamentals. This model was developed by economist Rudiger Dornbusch in 1976 and is often referred to as the "Dornbusch overshooting model."

Rudiger Dornbusch, the economist who developed the overshooting model.

Theoretical Background

The overshooting model is based on the assumption that prices of goods and services are sticky in the short run, meaning they do not adjust immediately to changes in economic conditions. In contrast, financial markets, including the foreign exchange market, adjust quickly to new information. This discrepancy in adjustment speeds leads to the phenomenon of exchange rate overshooting.

Key Assumptions

• Sticky Prices: Prices in the goods market are slow to adjust due to menu costs and other frictions.
• Flexible Exchange Rates: Exchange rates can adjust rapidly in response to changes in monetary policy or other economic shocks.
• Rational Expectations: Economic agents form expectations about future economic variables in a rational manner, using all available information.

Mechanism of Overshooting

When a country experiences a monetary expansion, such as an increase in the money supply, the immediate effect is a decrease in interest rates. According to the interest rate parity condition, lower domestic interest rates lead to a depreciation of the domestic currency in the foreign exchange market.

However, because prices are sticky, the initial depreciation of the currency is larger than what would be required to reach a new long-term equilibrium. This is the "overshooting" effect. Over time, as prices adjust, the exchange rate gradually moves back towards its long-term equilibrium level.

Implications

The overshooting model has several important implications for policymakers and economists:

• Exchange Rate Volatility: It explains why exchange rates can be more volatile than expected based on changes in economic fundamentals alone.
• Policy Effectiveness: It highlights the importance of considering the speed of adjustment in different markets when designing monetary policy.
• Expectations Management: It underscores the role of expectations in determining exchange rate movements and the potential for speculative attacks.

Criticisms

While the overshooting model provides valuable insights, it has been criticized for its reliance on the assumption of sticky prices and rational expectations. Some economists argue that these assumptions may not hold in all situations, leading to different exchange rate dynamics.

Related Pages

• Exchange rate
• Monetary policy
• Interest rate parity
• Rational expectations