Overshooting model

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.

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.

Mechanism

The model relies on the differential speed at which markets adjust: the foreign exchange market adjusts quickly to new information, while goods markets adjust more slowly due to price stickiness. This discrepancy leads to the temporary "overshooting" of the exchange rate.

1. Monetary Expansion: The central bank increases the money supply. 2. Immediate Effects: Interest rates fall, leading to a depreciation of the currency. 3. Overshooting: The currency depreciates more than what is necessary for long-term equilibrium. 4. Adjustment: Over time, as prices in the goods market adjust, the economy moves towards its new equilibrium, and the exchange rate corrects itself.

Implications

The Overshooting Model has several key implications for economic policy and exchange rate behavior: - It explains why exchange rates can be highly volatile following 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. - It highlights the importance of managing expectations in monetary policy to mitigate the effects of overshooting.

Criticism

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.

Conclusion

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.