Background
Exchange rate overshooting refers to a phenomenon in the foreign exchange market where the exchange rate initially adjusts more than required to a new equilibrium level in response to changes in the market. This can occur due to various factors, such as different speeds at which asset and goods markets adjust to new economic conditions.
Historical Context
The concept of exchange rate overshooting was extensively developed in the 1970s, becoming well-known through the works of economists like Rudiger Dornbusch. The concept emerged during a period of floating exchange rates following the collapse of the Bretton Woods system, as economists aimed to understand the often exaggerated short-term responses of exchange rates to economic shocks.
Definitions and Concepts
In economic terms, exchange rate overshooting describes a scenario where an adjustment to the exchange rate occurs in such a way that the initial jump overshoots the new equilibrium level. This happens because the asset markets typically adjust more swiftly than goods markets. Once goods prices begin to align with the new market conditions, the exchange rate will stabilize at its new equilibrium position.
Major Analytical Frameworks
Classical Economics
Classical economics primarily focused on the long-term determination of exchange rates by fundamental factors. While the concept of overshooting was not explicitly discussed, the underlying principles about price adjustments underlie some interpretations of overshooting.
Neoclassical Economics
Neoclassical theory incorporates anticipations and market efficiencies. Overshooting in this framework can be seen as a short-term inefficiency or market response to macroeconomic policies or external shocks before returning to equilibrium through market forces.
Keynesian Economics
Within Keynesian models, emphasis is placed on the stickiness of prices and wages. This analysis suggests that overshooting may occur due to rigidities and slower adjustments in the input markets, combined with rapid financial market reactions.
Marxian Economics
Marxian economics, which primarily critiques capitalistic exchanges and dynamics, does not specifically address exchange rate overshooting within its core doctrines. It may, however, acknowledge exchange phenomena through the lens of imbalance caused by differential adjustments across various markets.
Institutional Economics
Institutional economics might examine how regulatory frameworks, market structures, and institutional behaviors contribute to overshooting. These analyses often highlight the role of non-market entities in the persistence or mitigation of overshooting effects.
Behavioral Economics
In behavioral economics, overshooting can be attributed to irrational behaviors, herd mentality, or Technically-inaccurate anticipations by market participants reacting more sharply than is justified by changes in the fundamentals.
Post-Keynesian Economics
Post-Keynesian analysis continues the focus on price and wage stickiness but adds rich detail on expectations, the roles of uncertainty, and how these factors contribute to phenomena like overshooting.
Austrian Economics
Austrian economists might interpret overshooting as a result of interventionist policies distorting natural market equilibria, leading to exaggerated adjustments when market perceptions shift.
Development Economics
In the context of development economics, overshooting might be studied with regard to currency market interventions, exchange rate regimes, and the impact on developing economies, where market mechanisms and their stability may differ from advanced economies.
Monetarism
Monetarists may attribute overshooting to changes in monetary policy, echoing Dornbusch’s model where adjustments in money supply and interest rates trigger immediate, albeit excessive, exchange rate responses.
Comparative Analysis
Different economic schools provide varying explanations for exchange rate overshooting, each emphasizing distinct market mechanisms and reactions. This phenomenon’s understanding depends heavily on recognition of which market (asset vs goods) is faster to reflect new information and respond to policy changes.
Case Studies
Case Study 1: Volcker Shock of the Early 1980s
High-interest rates in the US led to a significant appreciation of the dollar, illustrating a case of overshooting. Once nearer equilibrium was achieved after goods prices adjusted, the exchange rate stabilized to a more predictable level.
Case Study 2: 1992 British Pound Crisis
The British Pound’s dramatic adjustment when the UK exited the ERM revealed instances of overshooting, characterized by abrupt market corrections before settling.
Suggested Books for Further Studies
- “Exchange Rate Overshooting and Monetary Policy” by Rudiger Dornbusch
- “Exchange Rate Econometrics” by Ronald MacDonald and Ian W. Marsh
- “The Economics of Exchange Rates” by Lucio Sarno and Mark P. Taylor
Related Terms with Definitions
- Interest Rate Parity: The theory that arbitrage in international financial markets ensures that the difference in interest rates across countries is equal to the forward discount or premium for their currencies.
- Purchasing Power Parity (PPP): A doctrine that states that in the long run, the exchange rate between two
