Overshooting Model

Overshooting model (Dornbusch's model) refers to excessive short-term movement of exchange rates due to fluctuations in monetary supply arising from price stickiness. Economists had proposed to solve the problem of the forward discount puzzle along with the observance of high exchange rate volatility levels.

Experts help explain and understand the sharp changes in exchange rates every day. It occurs because across markets. However, a speed difference remains in adjustment in sticky goods price and the financial markets price that instantaneously adjusts in the market.

• The overshooting model is an economic model that describes the excessive volatility of currency in the short run compared to long-run equilibrium.
• It suggests addressing the forward discount puzzle while keeping an eye on excessive levels of exchange rate volatility.
• The underlying presumption of the theory is that while product prices are expected to stay stable in the short term, currency prices will continue to fluctuate.
• The four assumptions to the theory are - exchange rates exhibit flexibility, demand for money gets completely influenced by production output and interest rates, uncovered interest parity (UIP) gets applicable & To counteract monetary shocks, goods prices remain constant in the short term but continue to adjust over time progressively.

Overshooting economics model of the exchange rate refers to a model to explain the higher levels of exchange rate volatility. One of the main features of the theory has been the assumption that product price remains sticky in the short term, but the currencies price remains volatile. German Economist Rudiger Dornbusch put forward the Dornbusch overshooting of exchange rate model in the research paper- Expectations and Exchange Rate Dynamics in 1976.

As per Dornbusch's model, markets would first achieve equilibrium whenever a country's monetary policy changes with a decrease in interest rates. But, the sticky nature of prices would first reach a new short-term equilibrium. However, the equilibrium prices remain sticky as they are based on old prices. Therefore, with the change and adjustment of goods price, the exchange rate would change again.

Hence, one observes that initially, the exchange rate tends to overshoot by a maximum level as they remain based on the older goods price. With suitable adjustments by the market of the product, the exchange rates also adjust. Furthermore, it is for this reason that exchange rates and goods prices would achieve the long-run equilibrium. As a result, the economy creates excess volatility in the exchange rate.

Therefore, one may observe that too much change initially occurs with overshooting exchange prices. As a result, it needs to be corrected to reflect these changes within the product market because it had failed to take them into account in the beginning. One more significant implication of the Dornbusch model has been that currency would appreciate even if a country's interest rates go lower.

It happens because the initial currency depreciation has been too much. As a result, the exchange rate adjusts to comply with the long-run equilibrium and appreciates. Thus, this phenomenon explains the forward discount puzzle.

One needs to understand the assumptions used in overshooting model to understand the concept better. The following three assumptions are the foundation stone of Dornbusch's model:

Assumption #1

It assumes that exchange rates exhibit flexibility.

Assumption #2

The uncovered interest parity (UIP) gets applicable. As a result, the difference between United States interest rates and the Eurozone interest will be equal to that of the expected depreciation rate of the US dollar.

Assumption #3

The demand for money entirely depends on the production output and the interest rate.

Assumption #4

Goods prices remain fixed in the short run but keep adjusting slowly in the long run to counter the monetary shocks. So, increasing the money supply level gest fully reflected by the increasing price of goods in the long run. However, one must note that the increase in price level includes the exchange rate and foreign currency prices.

One must be aware that Dornbusch's model terminology has become common in all modern international macroeconomics. Thus, one can find it essential in forecasting macroeconomics and an economy's future responses concerning changes in monetary prices. Moreover, Dornbusch's model concept successfully explains a significant empirical regularity in that the exchange rates experience more volatility than the goods price and interest rates.

It is also quite interesting to note that goods prices gradually adjust to their new level in the long run, but the exchange rates keep bouncing from one level to another for a long time. As a result, one finds extreme volatility in exchange rates and relatively more minor volatility in other prices. Nevertheless, unlike other models, Dornbusch's model does not help much in exchange rate prediction as the data does not prove its UIP assumptions.

Let us look at some overshooting examples to understand the concept clearly.

Example #1

In 2022, the US dollar appreciated at an extremely high level not seen in the last decade. As a result, many countries have started experiencing sudden volatility in their foreign-exchange markets, which they feel is undesirable. Hence, the exchange rate volatility has led to Dornbusch's model of the dollar to such an extent that many countries had to increase the central bank rates despite plunging domestic markets and tumbling growth.

Example #2

The European Central Bank (ECB) has said that its monetary policy has not got influenced as much as desired by the exchange rate channel. It has been trying to remain neutral, but the stank taken by it has not been enough. The inability of the ECB has led to overshooting of the foreign exchange rate due to the transmission protection instrument (TPI).

Depending on whether researchers are studying short-run or long-run analysis, the impact of a change in monetary policy on the exchange rates varies under this model.

According to Dornbusch, in 1976, currency rates in the short-term overshoot their long-term values due to changes in monetary policy. Here, we quickly examine how changing monetary policy will ultimately affect the economy. Then go through the short-term overshooting of exchange rates. Through analysis, we assume that the amount of money in circulation has unexpectedly increased permanently. Similarly, one can understand the analysis for a decrease in the money supply.

1. Long-run Analysis

Long-term output is at full employment and when prices are open-ended. A rise in the money supply causes a rise in overall demand. Since output will remain constant at its most significant level, an equal-proportional rise in the price level will maintain the actual money supply level. Real exchange rates will remain constant while the exchange rate, or e, rises. Therefore, the actual variables—accurate money supply, real exchange rates, real output, and real income—as well as the domestic interest rates—will not be impacted.

2. Short-run Analysis

Short-term pricing changes are slow to occur. However, if the money supply unexpectedly and permanently increases, currency rates will become highly volatile and devalue significantly.

This article has been a guide to Overshooting Model (Dornbusch) and its definition. Here, we explain its assumptions, exchange rate examples, and relation with monetary policy change.You may also find some useful articles here -

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