Overshooting model: Difference between revisions

Latest revision as of 11:40, 15 February 2025

Overview[edit]

The overshooting model is a concept in international finance and macroeconomics that explains why exchange rates can be more volatile than the underlying economic fundamentals. This model was developed by economist Rudiger Dornbusch in 1976 and is often referred to as the "Dornbusch overshooting model."

Rudiger Dornbusch, the economist who developed the overshooting model.

Theoretical Background[edit]

The overshooting model is based on the assumption that prices of goods and services are sticky in the short run, meaning they do not adjust immediately to changes in economic conditions. In contrast, financial markets, including the foreign exchange market, adjust quickly to new information. This discrepancy in adjustment speeds leads to the phenomenon of exchange rate overshooting.

Key Assumptions[edit]

Sticky Prices: Prices in the goods market are slow to adjust due to menu costs and other frictions.
Flexible Exchange Rates: Exchange rates can adjust rapidly in response to changes in monetary policy or other economic shocks.
Rational Expectations: Economic agents form expectations about future economic variables in a rational manner, using all available information.

Mechanism of Overshooting[edit]

When a country experiences a monetary expansion, such as an increase in the money supply, the immediate effect is a decrease in interest rates. According to the interest rate parity condition, lower domestic interest rates lead to a depreciation of the domestic currency in the foreign exchange market.

However, because prices are sticky, the initial depreciation of the currency is larger than what would be required to reach a new long-term equilibrium. This is the "overshooting" effect. Over time, as prices adjust, the exchange rate gradually moves back towards its long-term equilibrium level.

Implications[edit]

The overshooting model has several important implications for policymakers and economists:

Exchange Rate Volatility: It explains why exchange rates can be more volatile than expected based on changes in economic fundamentals alone.
Policy Effectiveness: It highlights the importance of considering the speed of adjustment in different markets when designing monetary policy.
Expectations Management: It underscores the role of expectations in determining exchange rate movements and the potential for speculative attacks.

Criticisms[edit]

While the overshooting model provides valuable insights, it has been criticized for its reliance on the assumption of sticky prices and rational expectations. Some economists argue that these assumptions may not hold in all situations, leading to different exchange rate dynamics.

Related Pages[edit]

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-'''Overshooting Model''' is a concept in [[macroeconomics]] that explains how [[exchange rates]] and other [[economic variables]] respond to changes in [[monetary policy]] and other economic shocks before eventually stabilizing. The model, primarily associated with the work of economist [[Rudi Dornbusch]] in his 1976 paper, "Expectations and Exchange Rate Dynamics," illustrates how an economy can temporarily exceed its long-run equilibrium following a change in monetary conditions.
+{{DISPLAYTITLE:Overshooting Model}}
-==Overview==
+== Overview ==
-The Overshooting Model posits that when a country's central bank changes its [[monetary policy]]—for instance, by increasing the [[money supply]]—it initially leads to a decrease in [[interest rates]]. Lower interest rates, in turn, reduce the demand for the country's currency on the [[foreign exchange market]], leading to an immediate depreciation beyond its long-term equilibrium level. This depreciation makes domestic goods cheaper for foreigners, increasing [[exports]] and decreasing [[imports]], which gradually restores the currency's value to its equilibrium level.
+The '''overshooting model''' is a concept in international finance and macroeconomics that explains why exchange rates can be more volatile than the underlying economic fundamentals. This model was developed by economist [[Rudiger Dornbusch]] in 1976 and is often referred to as the "Dornbusch overshooting model."
-==Mechanism==
+[[File:Dornbusch1.jpg|thumb|right|Rudiger Dornbusch, the economist who developed the overshooting model.]]
-The model relies on the differential speed at which markets adjust: the [[foreign exchange market]] adjusts quickly to new information, while [[goods market]]s adjust more slowly due to [[price stickiness]]. This discrepancy leads to the temporary "overshooting" of the exchange rate.
-. '''Monetary Expansion''': The central bank increases the money supply.
+== Theoretical Background ==
-. '''Immediate Effects''': Interest rates fall, leading to a depreciation of the currency.
+The overshooting model is based on the assumption that prices of goods and services are sticky in the short run, meaning they do not adjust immediately to changes in economic conditions. In contrast, financial markets, including the [[foreign exchange market]], adjust quickly to new information. This discrepancy in adjustment speeds leads to the phenomenon of exchange rate overshooting.
-. '''Overshooting''': The currency depreciates more than what is necessary for long-term equilibrium.
-. '''Adjustment''': Over time, as prices in the goods market adjust, the economy moves towards its new equilibrium, and the exchange rate corrects itself.
-==Implications==
+=== Key Assumptions ===
-The Overshooting Model has several key implications for economic policy and exchange rate behavior:
+* '''Sticky Prices:''' Prices in the goods market are slow to adjust due to menu costs and other frictions.
-- It explains why exchange rates can be highly volatile following economic shocks.
+* '''Flexible Exchange Rates:''' Exchange rates can adjust rapidly in response to changes in monetary policy or other economic shocks.
-- It suggests that monetary policy can have a more pronounced effect on exchange rates in the short run than in the long run.
+* '''Rational Expectations:''' Economic agents form expectations about future economic variables in a rational manner, using all available information.
-- It highlights the importance of managing expectations in monetary policy to mitigate the effects of overshooting.
-==Criticism==
+== Mechanism of Overshooting ==
-Critics of the Overshooting Model argue that it relies on assumptions that may not hold in reality, such as perfect capital mobility and the absence of currency intervention by governments. Additionally, empirical evidence supporting the model is mixed, with some studies finding that exchange rates do not always behave as the model predicts.
+When a country experiences a monetary expansion, such as an increase in the money supply, the immediate effect is a decrease in interest rates. According to the [[interest rate parity]] condition, lower domestic interest rates lead to a depreciation of the domestic currency in the foreign exchange market.
-==Conclusion==
+However, because prices are sticky, the initial depreciation of the currency is larger than what would be required to reach a new long-term equilibrium. This is the "overshooting" effect. Over time, as prices adjust, the exchange rate gradually moves back towards its long-term equilibrium level.
-Despite its limitations, the Overshooting Model remains a fundamental concept in international macroeconomics, providing valuable insights into the dynamics of exchange rates and the impact of monetary policy. It underscores the complex interplay between markets and the importance of expectations in economic behavior.
-[[Category:Economics]]
+== Implications ==
+The overshooting model has several important implications for policymakers and economists:
+* '''Exchange Rate Volatility:''' It explains why exchange rates can be more volatile than expected based on changes in economic fundamentals alone.
+* '''Policy Effectiveness:''' It highlights the importance of considering the speed of adjustment in different markets when designing monetary policy.
+* '''Expectations Management:''' It underscores the role of expectations in determining exchange rate movements and the potential for speculative attacks.
+== Criticisms ==
+While the overshooting model provides valuable insights, it has been criticized for its reliance on the assumption of sticky prices and rational expectations. Some economists argue that these assumptions may not hold in all situations, leading to different exchange rate dynamics.
+== Related Pages ==
+* [[Exchange rate]]
+* [[Monetary policy]]
+* [[Interest rate parity]]
+* [[Rational expectations]]
+[[Category:International finance]]
 [[Category:Macroeconomics]]
-[[Category:Monetary Economics]]
-{{Econ-stub}}