What Is Overshooting?
In economics, overshooting describes high levels of volatility in currency exchange rates, explained through the concept of price stickiness.
Key Takeaways
- Overshooting connects sticky prices to volatile exchange rates.
- Prices of goods don’t immediately react to shifts in exchange rates.
- Financial and money markets respond first, influencing the prices of goods over time.
The Origins of Overshooting
Introduced by economist Rüdiger Dornbusch, overshooting became well-known through his 1976 paper, “Expectations and Exchange Rate Dynamics,” published in the Journal of Political Economy. Dornbusch’s model, rejecting the traditional view that markets smoothly reach equilibrium, argues that short-term equilibrium is achieved in financial markets, and long-term stability follows as good prices gradually adjust.
Price Stickiness: What Does It Mean?
Price stickiness refers to the slow response of some prices to changes within the market. Dornbusch’s model highlights that exchange rates react quickly to monetary policy, but goods prices adjust more slowly, demonstrating inherent market volatility.
The Mechanics of the Overshooting Model
According to the overshooting model, initial overreactions in the foreign exchange rate due to monetary policy changes balance sticky good prices. In the short term, equilibrium is reached via financial market shifts, while the actual prices adjust gradually. This leads to more fluctuation in exchange rates than anticipated until prices stabilize over the long run.
Why Price Stickiness Matters
Initially controversial, the assumption of sticky prices has been validated by empirical observations. Dornbusch’s Overshooting Model is now foundational in international economics, describing significant shifts as the global economy transitioned to floating exchange rates.
The Broader Implications
The model holds that price ‘stickiness’—the lag in good prices adjusting to market conditions—undermines the rapid, predictable market corrections posited by classical economics. Exchange rates thereby remain volatile in the interim periods of price adjustment.
What Causes Volatility?
From Dornbusch’s perspective, exchange rate volatility arises because financial markets react promptly to monetary policy changes, unlike goods prices. Such volatility persists until an alignment of good prices with new market conditions is achieved.
Conclusion
Overshooting provides valuable insight into why exchange rates exhibit marked volatility. Dornbusch’s model underscores how exchange rates react intensely to monetary policies, stabilizing only once goods prices catch up, resulting in a new equilibrium.
Related Terms: exchange rate, price stickiness, monetary policy, foreign exchange market, financial market, volatility, equilibrium, inflation.
References
- Journal of Political Economy. “Expectations and Exchange Rate Dynamics”, Pages 1161-1176.
- International Monetary Fund. “Dornbusch’s Overshooting Model After Twenty-Five Years”, Page 3.
- International Monetary Fund. “Dornbusch’s Overshooting Model After Twenty-Five Years”, Page 14.
