DEFINITION of 'Overshooting'

A phenomenon in economics used to explain why exchange rates are more volatile than would be expected. Some economists had argued that volatility was purely the result of speculators and inefficiencies in the foreign exchange market. However, the overshooting model argues that the foreign exchange rate will temporarily overreact to changes in monetary policy to compensate for sticky prices in the economy. Thus, there will be more volatility in the exchange rate due to overshooting and subsequent corrections that would otherwise be expected.

BREAKING DOWN 'Overshooting'

Overshooting was introduced by German economist Rudi Dornbusch in the famous paper "Expectations and Exchange Rate Dynamics," published in 1976. The model is now widely known as the Dornbusch Overshooting Model. Although Dornbusch's model was compelling, at the time it was also regarded as somewhat radical due to its assumption of sticky prices. Today, however, sticky prices are widely accepted as fitting with empirical economic observations. Dornbusch's Overshooting Model is regarded as a forerunner to modern international economics.

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