Exchange Rate Overshoot Hypothesis (Overshooting Model)

The Exchange Rate Overshoot Hypothesis, often referred to as the Overshooting Model, is a concept in foreign exchange (FX) trading.

It offers an explanation for the often volatile short-term movements in exchange rates.

Understanding this hypothesis can provide FX traders with insights into the dynamics of the currency markets they trade.

Key Takeaways – Exchange Rate Overshoot Hypothesis

• Explanation for Exchange Rate Volatility:
  • The Exchange Rate Overshoot Hypothesis explains the excessive volatility in exchange rates.
  • It posits that exchange rates will temporarily overshoot their long-term equilibrium levels in response to a change in monetary policy.
  • This can lead to fluctuations that are larger than warranted by changes in underlying economic fundamentals.
• Adjustment Process:
  • The hypothesis suggests that when monetary policy changes, prices of goods and services are slow to adjust, causing the exchange rate to overreact initially.
  • Over time, as prices adjust, the exchange rate will gradually return to its new equilibrium level, reflecting the change in monetary policy.
• Policy Implications:
  • It highlights the potential for significant and rapid exchange rate movements following monetary policy changes.
  • This highlights the importance of considering these effects when making policy or trading decisions.

What is the Overshooting Model?

The Overshooting Model was introduced by economist Rudi Dornbusch in 1976.

It suggests that in response to a change in monetary policy, exchange rates will initially “overshoot” their long-term equilibrium level.

This is before eventually settling back to that equilibrium.

The Mechanics Behind the Model

The model is rooted in the difference between how quickly goods markets and asset markets adjust to changes.

• Asset markets, like those for currencies, adjust almost instantaneously to new information or policy changes.
• Goods markets, on the other hand, adjust more slowly due to factors like transportation costs, contracts, and other frictions.

Why Does Overshooting Occur?

When a central bank implements a monetary policy change, such as an interest rate cut, it can lead to an immediate drop in the currency’s value.

This is because lower interest rates typically reduce foreign capital inflows, making the currency less attractive to investors.

However, the actual goods market can’t react as swiftly because it’s not simply money and credit flows at work.

This leads to a temporary misalignment between the currency’s value and the underlying fundamentals of the economy.

This misalignment is what causes the currency to “overshoot” its long-term value.

Implications for FX Traders

For FX traders, the Overshooting Model provides a framework to anticipate short-term currency fluctuations following monetary policy changes.

Understanding that currencies might initially move more than their long-term fundamentals would suggest trading opportunities.

However, the overshooting effect is temporary.

Eventually, the currency will revert to its equilibrium level, influenced by the underlying economic fundamentals.

Critiques of the Overshooting Model

Some argue that the model oversimplifies the complex factors influencing exchange rates.

Others believe that goods markets might adjust faster than the model suggests.

Despite these critiques, the model remains a foundational concept in international finance and FX trading.

Exchange Rate Overshoot Hypothesis vs. Purchase Price Parity (PPP)

The Exchange Rate Overshoot Hypothesis posits that in response to a sudden monetary policy change, exchange rates will initially “overshoot” their new equilibrium level and then gradually return to it, due to the faster adjustment of financial markets compared to goods markets.

On the other hand, Purchasing Power Parity (PPP) asserts that in the long run, exchange rates will adjust to equalize the purchasing power of two currencies, meaning a basket of goods will cost the same in both currencies when converted.

While the Overshooting Model focuses on short-term volatility, PPP emphasizes long-term equilibrium.

FAQs – Exchange Rate Overshoot Hypothesis (Overshooting Model)

What is the Exchange Rate Overshoot Hypothesis?

The Exchange Rate Overshoot Hypothesis, often referred to as the Overshooting Model, is an economic theory proposed by economist Rudi Dornbusch in 1976.

It suggests that in response to a sudden change in monetary policy, exchange rates will initially “overshoot” their new long-term equilibrium level and then gradually converge back to that level over time.

This phenomenon occurs because financial markets adjust more rapidly than goods markets.

Why does overshooting occur in exchange rates?

Overshooting occurs because of the different speeds at which financial markets and goods markets adjust to shocks (new information that wasn’t priced in).

Financial markets, like the FX market, are highly liquid and can adjust almost instantly to new information or policy changes.

In contrast, goods markets, with physical commodities and products, take longer to adjust due to factors like production times, transportation, and other frictions.

When a monetary policy change occurs, the immediate reaction in the financial markets can lead to an exaggerated change in the exchange rate, which then corrects itself as the goods market catches up.

As we’ve written in other articles, the financial economy leads the real economy.

How does the Overshooting Model explain currency volatility?

The Overshooting Model provides a framework for understanding why currencies can exhibit significant short-term volatility in response to economic shocks, even if the long-term fundamentals remain unchanged.

According to the model, when a sudden change in monetary policy or another economic shock occurs, the immediate and rapid adjustment in the financial markets can lead to a temporary misalignment of the exchange rate.

This misalignment, or “overshoot,” is then corrected over time as the slower-moving goods market adjusts, leading to currency volatility.

What are the implications of the Overshooting Model for policymakers?

For policymakers, the Overshooting Model emphasizes the importance of considering the short-term effects of monetary policy changes on exchange rates.

While the long-term effects might align with policy objectives, the short-term volatility can have unintended consequences, such as destabilizing financial markets or affecting international trade.

Policymakers need to be aware of these potential outcomes and may need to consider complementary policies to mitigate adverse short-term effects if they disrupt policy goals.

What are the criticisms of the Exchange Rate Overshoot Hypothesis?

Some argue that the Overshooting Model oversimplifies the complexities of financial and goods markets.

Others believe that the model doesn’t adequately account for other factors influencing exchange rates, such as fiscal policies, investor flows and positioning for other reasons, or geopolitical events.

Additionally, while the model provides a theoretical framework, empirical evidence of overshooting has been mixed, with some studies supporting the hypothesis and others refuting it.

Virtually all academic models inherently simplify, and work as a starting point from which to work.

How does the Overshooting Model relate to other exchange rate theories?

The Overshooting Model is one of several theories that try to explain the behavior of exchange rates.

While it focuses on the short-term dynamics following a monetary shock, other theories, like the Purchasing Power Parity (PPP) or the Interest Rate Parity, emphasize long-term equilibrium conditions.

The Overshooting Model can be seen as complementary to these theories, offering ideas into the short-term deviations from the long-term equilibria predicted by other models.

In what scenarios is the Overshooting Model most relevant?

The Overshooting Model is particularly relevant in scenarios where there are sudden and significant changes in monetary policy, such as sharp interest rate hikes or cuts, or aggressive quantitative easing measures.

In such situations, the model can provide insight into the potential short-term volatility in exchange rates, even if the long-term fundamentals remain unchanged.

Why do exchange rates tend to overshoot?

Exchange rates tend to overshoot because financial markets adjust instantaneously to monetary policy changes, while goods and services markets adjust more slowly.

When a monetary policy change leads to an expectation of depreciation or appreciation, traders quickly move their capital, causing the exchange rate to overshoot its long-term equilibrium.

As goods and services prices slowly adjust, the exchange rate eventually settles back to its new equilibrium level, reflecting the altered monetary policy.

Are there cases where exchange rates undershoot and then keep drifting to the new equilibrium level?

Yes, exchange rates can also undershoot in response to new information or policy changes, and then gradually drift towards the new equilibrium level.

This can occur when the market initially underreacts to new information, leading to a smaller immediate change in the exchange rate than is warranted by the new equilibrium.

As market participants gradually process the information and adjust their expectations and transactions, the exchange rate will continue to move toward the new equilibrium level.

The speed and path of this adjustment can be influenced by various factors, including additional information releases, market sentiment, and other economic events.

But doesn’t that undermine the Overshoot Model?

The possibility of undershooting doesn’t necessarily undermine the Exchange Rate Overshoot Hypothesis, but it does highlight the complexity and variability of exchange rate movements in response to new information or policy changes.

The Overshoot Model is a theoretical framework that explains a specific type of behavior in exchange rates. But it does not account for all possible scenarios or market conditions.

In reality, exchange rate movements are influenced by a multitude of factors. Their responses to changes in monetary policy or other information can vary widely.

The Overshoot Model can provide insights into the dynamics of exchange rates, but like all models, it has its limitations and assumptions.

What’s a full list of factors that influence exchange rates?

For this, we will defer to our article here which covers the many variables that influence exchange rates.

Conclusion

The Exchange Rate Overshoot Hypothesis, proposed by economist Rudi Dornbusch in 1976, posits that exchange rates will temporarily overshoot their long-term equilibrium levels in response to a change in monetary policy.

This phenomenon occurs because financial markets adjust more rapidly to new information compared to goods markets.

This, in turn, leads to an immediate sharp change in exchange rates.

Over time, as goods prices adjust, the exchange rate will gradually return to its new equilibrium level, reflecting the change in monetary policy.