Definition
The overshooting model is a concept in international finance used to explain how exchange rates respond to monetary shocks. It suggests that exchange rates will initially overswing or ‘overshoot’ their long-term equilibrium levels after a change in monetary policy before settling back to equilibrium. The model, proposed by economist Rudi Dornbusch, portrays the market’s tendency to react strongly in the short term, but adjust slowly over time.
Key Takeaways
- The Overshooting Model is an economic theory that suggests that exchange rates will overreact to changes in monetary policy, leading to an “overshooting” of the new equilibrium point.
- Developed by economist Rudi Dornbusch, the model demonstrates how goods markets’ slow adjustment speed can cause large and quick movements in financial markets – this discrepancy in adjustment speed is what can result in overshooting.
- While it is mainly used as an explanatory and predictive tool for floating exchange rates, the Overshooting Model also provides insight on topics beyond exchange rate dynamics, such as the effects of unexpected monetary policy shifts or market expectations.
Importance
The Overshooting Model is important in finance because it provides insight into the behavior of exchange rates.
The model suggests that exchange rates will “overshoot” their long-term equilibrium levels in response to changes in monetary policy.
It allows economists and financial professionals to understand and predict how short-term fluctuations in monetary policy affect exchange rates, often leading to significant changes in the short run.
This knowledge is critical for businesses involved in international trade, as it directly impacts their profitability and risk management.
By understanding and forecasting these movements, one can hedge their risk, time their foreign currency transactions, and make informed investment decisions.
Explanation
The Overshooting Model is an essential tool in the domain of international finance, with the primary purpose of explaining the behavior of exchange rates. The model, proposed by economist Rudiger Dornbusch in 1976, provides a theoretical framework for understanding how exchange rates can change significantly due to an economic policy shift or an unexpected economic event.
It primarily serves as an apparatus to comprehend how monetary policy modifications can excessively affect the exchange rate in the short run compared to the long run. The Overshooting Model is grounded in the concept of price stickiness and the distinction between short-term and long-term effects on exchange rates.
It predicts that if a country’s monetary policy changes, specifically if there is monetary expansion or contraction, this change will cause an immediate and “overshooting” movement in exchange rates. This is because financial assets adjust swiftly to the policy change, while goods prices are slower due to various frictional forces (“stickiness”). Therefore, the exchange rate “overshoots” its long-run equilibrium value.
This model assists economists and policy-makers in anticipating exchange rate fluctuations and understanding why the forex market can be highly volatile.
Examples of Overshooting Model
The overshooting model is a term used in international economics to describe a situation where exchange rates overreact to changes in financial market variables. Here are three real-world examples:
Brexit Vote (2016): After the decision for the United Kingdom to leave the European Union (Brexit) was announced, the British pound heavily depreciated against other currencies, especially the US dollar, in immediate response. This strong response was partially an overshoot as the economic fundamentals did not change as quickly, dramatically, or permanently as the sharp depreciation suggested.
Global Financial Crisis (2008): During the global financial crisis in 2008, the overreaction of currency markets was seen clearly. The initial panic led to an extreme demand for perceived “safe currencies” like the U.S. dollar, and the currencies of emerging markets like India, Russia, South Africa, etc., depreciated at an alarming rate, much more than their economic fundamentals would warrant. This overreaction was later corrected.
Swiss Franc (2015): In 2015, the Swiss National Bank (SNB) surprisingly abandoned a cap on the franc’s value against the euro, which had been in place for three years to fight the risk of deflation. Right after the announcement, the Swiss franc appreciated rapidly, nearly 30% against the euro, an example of overshooting. It subsequently moderated a bit, but remained significantly stronger than before the announcement.Remember, in each of these examples, it’s the initial, possibly overreactive, swing that constitutes the overshoot; subsequent corrections do not negate the fact that overshooting occurred.
Overshooting Model FAQ
1. What is the Overshooting Model?
The Overshooting Model is an economic model hypothesized to explain the volatility of exchange rates. It presents the concept that exchange rates will react excessively in the short run to changes in monetary policy before stabilizing to a new level in the long run. This model was proposed by economist Rudi Dornbusch in 1976.
2. How does the Overshooting Model work?
The Overshooting Model works by assuming there are two types of goods, namely domestically-produced goods (non-tradables) and foreign-produced goods (tradables). It explains that changes in monetary policy lead to an immediate and excessive response in exchange rates due to market expectations, after which the exchange rates gradually return to their long-term equilibrium, therefore ‘overshooting’ their eventual position.
3. What are the main assumptions of the Overshooting Model?
The Overshooting Model relies on the assumption of nominal stickiness of wages and prices, the theory of purchasing power parity (PPP), and the difference in the flexibility between financial markets and goods markets. It is also implicitly assumed that there is perfect capital mobility.
4. What is the significance of the Overshooting Model?
The significance of the Overshooting Model lies in its capacity to explain the volatility of exchange rates observed in the real economy. It provides a theoretical basis for changes in exchange rates beyond what fundamental macroeconomic variables would suggest, especially in the short run.
5. What are the criticisms of the Overshooting Model?
One of the main criticisms of the Overshooting Model is related to its reliance on assumptions, such as perfect capital mobility, which may not hold in the real world. Additionally, the model assumes an immediate and excessive response of exchange rates to changes in monetary policy, a feature not always observed in practice.
Related Entrepreneurship Terms
- Exchange Rate Dynamics
- Sticky Prices
- Economic Shocks
- International Interest Rates
- Long-run Purchasing Power Parity (PPP)
Sources for More Information
- Investopedia: An in-depth, comprehensive resource for definitions of finance and investing terms.
- Economics Help: A resource dedicated to helping people understand economics concepts, including models and theories.
- JSTOR: A digital library for scholars, researchers, and students, providing access to thousands of academic journals, books, and primary sources from a wide variety of disciplines.
- The National Bureau of Economic Research: A private, nonprofit research organization providing high-quality, quantitative economic research that leads policy making on a global scale.
