EXCHANGE RATE OVERSHOOTING

The term overshooting indicates the excessive fluctuation of the nominal exchange rate in response to a change in the monetary supply. This phenomenon, first defined by Dornbusch (1976) and due to price stickiness, contributes to explaining the high volatility displayed by nominal exchange rates. The Dornbusch’s model assumes price stickiness (a reasonable assumption in the short run) and helps to explain why exchange rates move so sharply from day to day. Since prices do not adjust immediately, a monetary shock affects the real balances and the nominal interest rate. Let's consider, for example, a rise (decrease) in money supply. The Uncovered interest parity (UIP) implies a nominal depreciation (appreciation) to compensate for the negative (positive) spread between the domestic and the foreign nominal interest rate. Thus, the exchange rate adjusts instantaneously to equate supply with demand for foreign exchange, overshooting (undershooting) its long run equilibrium level. In the medium run, prices adjust according to the money supply and the exchange rate moves downward (upward). Hence, in the long run, the principle of neutrality is satisfied.
Bibliography
Dornbusch R. (1976), "Expectations and Exchange Rate Dynamics", The Journal of Political Economy, Vol. 84, pp. 1161-76.
Editor: Lorenzo CARBONARI
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