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Overshooting

Overshooting

BIBLIOGRAPHY

Overshooting is a term used in macroeconomics and international finance to describe the behavior of the exchange rate after the economy is hit with a shock (i.e., an unanticipated event of sufficient magnitude such that it affects aggregate income, the general level of prices, or the aggregate volume of employment). Further, overshooting is a theoretical concept and is not always observed in the data. This concept was introduced into the economics literature by Rudiger Dornbusch (19422002) in his 1976 article Expectations and Exchange Rate Dynamics, which is the most-cited professional article in international macroeconomics.

Overshooting describes the fact that before the exchange rate gets to its new long-run value in response to

a shock, it may initially move past or overshoot the new level to which it will eventually settle.

Figure 1 represents the response of the exchange rate (measured in U.S. dollars per euro) to an increase in the U.S. money supply. As one can see, in the short run the exchange rate overshoots (moves to a point higher than) its long-run value.

Theoretically, overshooting arises in an economic model that assumes: (1) exchange rates are flexible; (2) uncovered interest parity holds (i.e., the difference between interest rates in the U.S. and euro zone is equal to the expected rate of U.S. dollar depreciation); (3) money demand depends on interest rate and output; and (4) prices are fixed in the short run but they fully adjust to offset monetary shocks in the long run. Thus, in the long run, an increase in the money supply would be fully reflected in an increase in the price level, including the price of foreign currency, the exchange rate.

Since prices are sticky in the short run, they cannot adjust immediately, and therefore an increase in money supply would instead lower the interest rate in the United States. For the uncovered interest parity to hold, people should now be expecting the U.S. dollar to appreciate. At the same time, we know that in the long run the dollar exchange rate will converge to a more depreciated value; thus, immediately after the shock, the dollar has to depreciate by more than in the long run and then start appreciating, as shown in Figure 1.

The overshooting phenomenon is common to many modern theories in international macroeconomics that assume sticky prices in the short run. Thus, it is a necessary component of any macroeconomic forecast, as well as of the analysis of possible responses of the economy to monetary policy changes. Nevertheless, not all models, and not even all sticky-price models, predict overshooting in the behavior of the exchange rates.

The concept of overshooting helps explain an important empirical regularitythe fact that exchange rates are much more volatile than price levels or interest rates. Indeed, while prices adjust slowly and monotonically to their new long-run levels, exchange rates bounce around. In a world with numerous economic shocks, this leads to a high volatility of exchange rates and a much smaller volatility of prices.

The concept of overshooting does not help much in predicting exchange rates. This is partly due to the fact that one of the main assumptions of the model, the uncovered interest parity, is not borne out by the data. On the other hand, other models do not do a better job in predicting exchange rates than the overshooting model.

BIBLIOGRAPHY

Dornbusch, Rudiger. 1976. Expectations and Exchange Rate Dynamics. Journal of Political Economy 84 (6): 11611175.

Rogoff, Kenneth. 2002. Dornbuschs Overshooting Model After Twenty-Five Years. Mundell-Fleming Lecture. Second Annual IMF Research Conference. http://www.imf.org/external/np/speeches/2001/112901.htm.

Galina Hale

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