What Is Overshooting?

In economics, overshooting, also known as the exchange rate overshooting hypothesis, is a way to think about and explain high levels of volatility in currency exchange rates using the concept of price stickiness.

Key Takeaways

  • The overshooting model establishes a relationship between sticky prices and volatile exchange rates.
  • The model's main thesis is that prices of goods in an economy do not immediately react to a change in foreign exchange rates.
  • Instead, a domino effect first impacts other factors - such as financial markets, money markets, derivatives markets, and bond markets - which then transfers its influence onto the prices of goods.

Understanding Overshooting

Overshooting was introduced by German economist Rudiger Dornbusch, the renowned economist focusing 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 modern international macroeconomics."

The overshooting model is considered especially significant because it explained exchange rate volatility during a time when the world was moving from fixed to floating rate exchanges. According to Kennett Rogoff, IMF chief economist, the paper imposed "rational expectations" on private actors about exchange rates. "...rational expectations is a way of imposing overall consistency on one's theoretical analysis," he wrote on the paper's 25th anniversary.

The Overshooting Model

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-run, 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 prices of goods unstick and adjust to the reality of these financial market prices, the financial market, including the financial exchange market, also 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 prices 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.