Overshooting

Background

The concept of overshooting refers to situations in which certain economic variables, following a shock, temporarily exceed their long-run equilibrium values before settling back. The phenomenon is especially notable in foreign exchange markets but is applicable in other areas of economic activity as well.

Historical Context

The term overshooting gained significant traction in economic literature in the context of exchange rate theories, particularly following the work of economist Rudiger Dornbusch in the 1970s. Dornbusch’s model explained how exchange rates can overshoot their long-term values post monetary policy shifts.

Definitions and Concepts

Overshooting occurs when a sudden economic event, or shock, causes a temporary but exaggerated movement in economic variables. This overreaction happens because different parts of the economy adjust at different rates. Variables affected by overshooting eventually stabilize, but in the short term, they surpass their long-term equilibria.

Key Points:

Temporary overreaction to economic shocks.
Occurs mainly due to differing speeds of adjustment among variables.
Applies to various economic indicators such as exchange rates, interest rates, and prices.

Major Analytical Frameworks

Classical Economics

Classical economists seldom addressed overshooting explicitly, as their focus was more on long-term equilibrium states and less on short-term fluctuations.

Neoclassical Economics

Neoclassical models include assumptions of rational expectations and perfect markets but often get criticized for not accurately predicting short-term market anomalies like overshooting.

Keynesian Economics

Keynesian frameworks, which emphasize demand-side factors and market imperfections, offer a conducive ground for integrating overshooting as it aligns with the idea that markets do not always clear instantly.

Marxian Economics

Marxian economics doesn’t focus explicitly on overshooting, rather it looks at longer-term trends and systemic cycles grounded in capitalistic structures and class relations.

Institutional Economics

Institutionalists could argue that regulatory and policy frameworks, alongside norms and conventions, impact different adjustment speeds, hence contributing to overshooting.

Behavioral Economics

Behavioral economics examines psychological factors and their contribution to overshooting. Overreaction due to herd behavior, and cognitive biases about future expectations can exacerbate overshooting phenomena.

Post-Keynesian Economics

Post-Keynesian theories are open to the idea of market overshooting and consider it critical by emphasizing fundamental and persistent market frictions that slow down adjustment processes.

Austrian Economics

Austrian economists attribute overshooting to inevitable misallocations and information asymmetries that get corrected over time. Emphasis is on the process of discovery and entrepreneurship in correcting such overshoots.

Development Economics

Overshooting in development economics might refer to short-term bursts in prices (like commodity prices) in developing economies and their impact on long-run growth and inflation.

Monetarism

Monetarist frameworks, focusing on the role of money supply, acknowledge overshooting through mechanisms like Dornbusch’s exchange rate overshooting hypothesis, driven predominantly by sticky prices.

Comparative Analysis

Different economic schools offer diverse tools to analyze overshooting. Where classical models fall short, schools incorporating market imperfections (like Keynesian models) provide richer insights into the dynamic adjustment pathways and temporal fluctuations characteristic of overshooting.

Case Studies

Dornbusch Exchange Rate Overshooting Hypothesis (1976): Examines how sudden monetary policy changes lead to short-term significant exchange rate changes before settling back to equilibrium.
1985 Plaza Accord: Coordinated intervention to depreciate the US dollar, showcases how managed expectations impact short-term currency value fluctuations beyond the targeted levels.

Suggested Books for Further Studies

“Floating Exchange Rates: Theories and Evidence” by David Bigman and Teizo Taya
“Exchange Rate Efficiency and the Behavior of International Asset Markets” by Kathryn M. Dominguez
“Macroeconomic Theory: A Dynamic General Equilibrium Approach” by Michael Wickens
“Behavioral Economics: Toward a New Economics by Integration with Traditional Economics” by Kazuhiko Nomi & Hiroshi Kizaki

Exchange Rate Overshooting: An exaggerated, short-term adjustment of the exchange rate due to changes in monetary policy.
Rational Expectations: The hypothesis that consumers and firms optimally use all available information when making economic decisions.
Sticky Prices: The resistance of prices to change immediately in response to changes in supply and demand.