What is Overshooting
Overshooting, also known as the overshooting model, or the exchange rate overshooting hypothesis, is a way to think about and explain high levels of volatility in exchange rates.
BREAKING DOWN Overshooting
Overshooting was introduced by German economist Rudi Dornbusch, the renowned economist focussing on international economics, including monetary policy, macroeconomic development, growth and international trade. The model was first introduced in the famous paper "Expectations and Exchange Rate Dynamics," published in 1976 in the Journal of Political Economy. 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. Today, Dornbusch's Overshooting Model is widely regarded as the forerunner to modern international economics. In fact, some have said it "marks the birth of of modern international macroeconomics."
Overshooting Model, what it says
So, then, what does the overshooting model say? Before Dornbusch, economists generally believed that markets should, ideally, arrive at equilibrium, and stay there. Some economists had argued that volatility was purely the result of speculators and inefficiencies in the foreign exchange market, like asymmetric information, or adjustment obstacles. Dornbusch rejected this view. Instead, he argued that volatility was more fundamental to the market than this, much closer to inherent in the market than to being simply and exclusively the result of inefficiencies. More basically, Dornbusch was arguing that in the short-un, equilibrium is reached in the financial markets, and in the long run, the price of goods responds to these changes in the financial markets.
The overshooting model argues that the foreign exchange rate will temporarily overreact to changes in monetary policy to compensate for sticky prices of goods in the economy. This means that, in the short run, the equilibrium level will be reached through shifts in financial market prices, so, the foreign exchange market, the money market, the derivatives market, the bond market, the stock market etc, but not through shifts in the prices of goods themselves. Gradually, then, as the price of goods unsticks, and adjusts to the reality of these financial market prices, the financial market, including the financial exchange market, adjusts to this financial reality.
So, then, initially, foreign exchange markets overreact to changes in monetary policy, which creates equilibrium in the short term. And, as the price of goods gradually respond to these financial market prices, the foreign exchange markets temper their reaction, and create long-term equilibrium.
Thus, there will be more volatility in the exchange rate due to overshooting and subsequent corrections that would otherwise be expected.