What Exactly Is Overshooting?
In economics, overshoot, also known as the exchange rate overshoot hypothesis, is a way of thinking about and explaining the high volatility in exchange rates using the concept of price stickiness.
Key Highlights
- The overshoot model establishes a relationship between sticky prices and exchange rate fluctuations.
- The basic argument of the model is that the prices of goods in the economy do not respond instantaneously to changes in external prices.
- Instead, the domino effect first affects other factors (such as financial markets, financial markets, commodity markets, and financial markets), then changes its energy towards goods.
A Closer Look at Overshooting Explained
The concept of overshooting was introduced by Rüdiger Dornbusch, a distinguished German economist known for his work in international economics, monetary policy, macroeconomic development, and international trade. He first presented this idea in his influential 1976 paper, Expectations and Exchange Rate Dynamics, published in the Journal of Political Economy. The model that emerged from his work is now widely recognized as the Dornbusch Overshooting Model.
Prior to Dornbusch’s contribution, economists largely believed that markets naturally moved towards equilibrium and remained stable. Some argued that volatility in markets was solely caused by speculators and inefficiencies, such as asymmetric information or difficulties in market adjustments.
However, Dornbusch challenged this perspective. He proposed that market volatility was not merely the result of inefficiencies but was a more intrinsic characteristic of the market. His view emphasized that, in the short run, financial markets tend to reach equilibrium quickly, while the prices of goods and services adjust more gradually in the long run in response to changes in the financial markets.
The Concept of the Overshooting Model
The overshooting model suggests that foreign exchange rates will initially overreact to changes in monetary policy to compensate for the slower adjustment of goods prices in the economy. In the short term, equilibrium is achieved primarily through adjustments in financial market prices, rather than through changes in the prices of goods. Over time, as the prices of goods begin to adjust to the new financial market conditions, the financial markets, including foreign exchange markets, also adapt to reflect these changes.
In this process, foreign exchange markets initially experience an overshooting response to monetary policy changes, creating short-term equilibrium. As goods prices gradually align with the new financial market conditions, the foreign exchange market’s response moderates, leading to long-term equilibrium. This dynamic results in more volatility in exchange rates due to overshooting and subsequent adjustments, creating more fluctuations than would typically be anticipated.
Essential Considerations
Dornbusch’s model, although complex, was initially considered radical because of his theory of sticky prices. Today, price stickiness is often observed as a form of market analysis, and Dornbusch’s overshoot model is widely accepted as the leader of today’s global markets. In fact, he said it “marked the birth of modern international macroeconomics.” 2
The overshoot model is considered particularly important because it explains the changes in exchange rates that occurred when the world moved from fixed to floating exchange rates. Kenneth Rogoff, director of economics and research at the International Monetary Fund (IMF), said Dornbusch’s article “wanted private actors to be optimistic” about the stock market. Rogoff wrote on the 25th anniversary of his paper:
The Concept of ‘Sticky’ in Economic Theory?
In business, “stickiness” refers to the tendency of a product to change more slowly than the market and demand. This may be because retailers want to reduce food prices by avoiding frequent price changes, or because the timing of price changes is difficult to determine. The term for viscosity is nominal hardness.
What Does Overshooting Mean in Economics?
In economics, overpricing refers to the tendency for certain prices to overreact to changes in supply and demand. This is in contrast to classical economics, which argues that prices should eventually reach equilibrium prices. Overshooting is used to explain why exchange rates fluctuate more than stock levels.
What Drives Volatility in Exchange Rates?
The Dornbusch Overshoot model highlights that exchange rates are highly volatile because foreign exchange markets react swiftly to changes in monetary policy, whereas the adjustment of goods prices takes longer. As a result, exchange rates undergo considerable fluctuations following a change in monetary policy, until the prices of goods gradually reach a new equilibrium.
The Conclusion
The overshooting model, developed by economist Rüdiger Dornbusch, was designed to explain the high volatility often observed in exchange rates. According to this theory, exchange rates initially respond sharply to changes in monetary policy, and this volatility continues until the prices of goods adjust and a new equilibrium is reached.