What is overshoot?
The overshoot, also known as the overshoot model, or the exchange rate overshoot hypothesis, is a way to think about and explain the high levels of exchange rate volatility.
Understanding the overshoot
The overshoot was introduced by German economist Rudiger Dornbusch, the renowned economist specializing in international economics, including monetary policy, macroeconomic development, growth and international trade. The model was first introduced in the famous document “Expectations and Exchange Rate Dynamics”, published in 1976 in the Journal of Political Economy. The model is now widely known as the Dornbusch passing model. Although Dornbusch’s model was convincing, at the time it was also considered somewhat radical because of its sticky price assumption. Today, however, sticky prices are widely accepted as being in line with empirical economic observations. Today, Dornbusch’s model of overtaking is widely regarded as the precursor of the modern international economy. In fact, some have said that it “marks the birth of modern international macroeconomics”.
The overshoot model is considered particularly important because it explains the volatility of exchange rates at a time when the world was moving from fixed-rate trade to floating rates. According to Kennett Rogoff, chief economist of the IMF, the paper imposed “rational expectations” on private actors regarding exchange rates. “… rational expectations are a means of imposing global consistency on his theoretical analysis,” he wrote on the occasion of the newspaper’s 25th anniversary.
Key points to remember
- The overrun model establishes a relationship between sticky prices and volatile exchange rates.
- The main thesis of the article is that the prices of goods in an economy do not react immediately to a change in exchange rates. Instead, a domino effect that encompasses other actors – financial markets, money markets, derivatives markets, bond markets – helps shift its effect on the prices of goods.
Exceeding model, what it says
So what does the overshoot model say? Before Dornbusch, economists generally believed that markets should ideally strike a balance and stay there. Some economists had argued that volatility was only the result of speculators and inefficiencies in the foreign exchange market, such as asymmetric information or obstacles to adjustment.
Dornbusch rejected this view. Instead, he argued that volatility was more fundamental to the market than that, much closer to inherent in the market than to be simply and exclusively the result of inefficiencies. More fundamentally, Dornbusch argued that in the short term, equilibrium is reached in the financial markets and, in the long term, the price of goods responds to these changes in the financial markets.
The overrun model argues that the exchange rate will temporarily overreact to changes in monetary policy to compensate for the sticky prices of goods in the economy. This means that, in the short term, the equilibrium level will be reached through the variations of the prices of the financial markets, therefore, the foreign exchange market, the money market, the derivatives market, the bond market, the stock market, etc., but not through changes in the prices of the goods themselves. Gradually, then, as the price of goods takes off and adapts to the reality of these financial market prices, the financial market, including the foreign exchange market, adapts to this financial reality.
Thus, initially, the foreign exchange markets react excessively to changes in monetary policy, which creates a short-term equilibrium. And, as the price of goods gradually reacts to these financial market prices, the foreign exchange markets temper their reaction and create a long-term equilibrium.
Thus, there will be more volatility in the exchange rate due to the overshoot and subsequent corrections that would otherwise be expected.