Economics
Overshooting
Overshooting refers to a temporary exchange rate movement that exceeds its long-term equilibrium value. This phenomenon occurs due to the adjustment process of the exchange rate to changes in economic fundamentals, such as interest rates, inflation, and productivity. Overshooting can have both positive and negative effects on the economy, depending on the specific circumstances.
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eBook - PDFThe International Monetary System
Highlights From Fifty Years Of Princeton's Essays In International Finance
- Peter B Kenen(Author)
- 2019(Publication Date)
- Taylor & Francis(Publisher)
10 In Frankel (1983b), I demonstrate formally, in the Dornbusch Overshooting model, that if the market overestimates the future rate of change of the exchange rate, the degree of volatility is less than it would be under rational expectations. A smaller increase in the current value of the currency becomes sufficient to generate the expected future depreciation necessary to offset a given interest differential, so Overshooting is less extreme. Six Meanings of Overoaluation 311 the market might expect the spot rate to move in the opposite direction from long-run equilibrium. Such expectations could even be rational if they are self-validating. This is the possibility of the speculative bubble. Theorists have long been nettled by the saddle-path stability problem, a mathematical property of solutions to perfect-foresight models. Because of self-confirming expectations, there are an infinite number of paths that satisfy the condition that expectations are correct, only one of which constitutes a stable path toward the equilibrium that is based on fundamentals alone. The typical strategy has been to rule out the explosive solutions by assumption. 11 This strategy has seemed justified by the observation that there have in fact been relatively few episodes in history that one would want to nominate as speculative bubbles, and none that did not eventually come to an end. As soon as one admits that any bubble must eventually burst, rational expecta-tions would seem to prevent it from ever getting started in the first place. But there has been an interesting theoretical development in this area-a recognition that one can easily build in at each point in time a probability of the collapse of the bubble and the return to fundamentals equilibrium (see Blanchard, 1979).
eBook - PDF- John F. Bilson, Richard C. Marston, John F. Bilson, Richard C. Marston(Authors)
- 2007(Publication Date)
- University of Chicago Press(Publisher)
In the present model, however, overshoot- ing of the exchange rate in response to monetary disturbances is not assured. If money demand responds strongly to deviations of the value of output from its equilibrium level (w is large), or if increases in the relative price of domestic goods have a strong negative effect on money demand (V is large and negative), then R may be less than one and @ = 1 - R may be positive. In this case, the actual exchange rate will rise by less than the conditional equilibrium exchange rate in response to an unanticipated in- crease in the money supply that increases p relative to p.40 The coefficient A determines the response of the value of domestic output to divergences between p and p . From (73) it follows that the strong pre- sumption that R is positive translates into a strong presumption that A is positive. Since y = -A - (p - p ) , a positive A means that y is negatively related to p - 9. As one should expect, a high value of p implies a low demand for domestic goods, and the producers of these goods (who tempo- rarily hold their price fixed) respond to this low demand by reducing the value of output of such goods below its equilibrium level. 40. In Dornbusch’s (1976) original analysis of exchange rate Overshooting, it is recognized that a strong response of income to an increase in the money supply may counteract the normal Overshooting effect of a monetary disturbance. 49 The Theory of Exchange Rate Determination 1.7.3 Disequilibrium Dynamics The preceding analysis indicates how current state of disequilibrium in the economy, at time I, is determined by the divergence between p(t) and its conditional equilibrium value p(t), and how this disequilibrium is ex- pected to disappear, at the exponential rate 6, as the economy converges toward its conditional equilibrium path.
eBook - PDF- Peter J. Montiel(Author)
- 2015(Publication Date)
- Wiley-Blackwell(Publisher)
In the event, the switch to floating was indeed associated with increased volatility of both nominal and real exchange rates. But this fact does not establish either that the increase in volatility was caused by the switch to floating exchange rates nor that the resulting volatility was ‘‘excessive.’’ These two issues are addressed in Boxes 12.1 and 12.2. Dornbusch essentially showed that the opponents of floating exchange rates had a point: for certain types of macroeconomic shocks, the induced movements in exchange rates would tend to be both larger and more prolonged than would be predicted by models such as the ones that we analyzed in the last two chapters. We will see that the crux of the explanation is precisely that the kind of equilibrium described by our short-run model is only reached gradually and that in response to certain types of shocks (specifically, monetary and external financial ones), the path followed by the exchange rate from its initial value to the new short- run equilibrium involves an initial adjustment that is larger than the eventual short-run adjustment. This is what is meant by the term Overshooting. 12.2 The Dornbusch Overshooting Model It is useful to begin by analyzing a very simple version of the Dornbusch Overshooting model. Specifically, we will assume that, rather than moving immediately to its new equilibrium after a shock, the level of real output in the economy adjusts with a one-period lag, as illustrated in Figure 12.1. Thus, when a shock arrives, say at time t in the figure, the economy’s level of output does not adjust in the first period, but remains at its initial pre- shock level Y 0 , determined by the economy’s past history. Only in the next period (period t þ 1) does the level of output adjust to its new equilibrium value Y 1 . Because lagged adjustment in the goods market means that real output Y is not free to adjust to shocks when Floating Exchange Rates III: Exchange Rate Dynamics 301
eBook - PDF- Imad A Moosa, Razzaque H Bhatti(Authors)
- 2009(Publication Date)
- World Scientific(Publisher)
Under perfect foresight, as soon as a certain percentage expansion in the money supply is announced, economic agents perceive the opportunity cost of holding domestic money to rise proportionally, with a consequent fall in the desired ratio of M /F . As the stock of domestic holdings of foreign currency cannot change instan-taneously, the level of wealth falls from ¯ W 0 to W 1 . This decline in wealth is inevitable, as the rise in the expected relative cost of holding domestic currency reduces the desired ratio of domestic to foreign currencies, which (given the initial value of foreign currency holdings, ¯ F 0 ) can be brought about only by a decline in M = M/S , and thus in W . As the initial nominal stock of domestic money ( M , at point A ) is given, the decline in M = M/S is brought about by a rise in the nominal exchange rate, S . As the real exchange rate is the ratio of the nominal exchange rate (S) to the price of non-traded goods (P N ) , it follows that ˙ S > ˙ P N . If the aggregate price level is a weighted average of S and P N , it follows that the exchange rate changes by more than the overall price level. This is what is known as the Overshooting phenomenon in the Calvo–Rodriguez (1977) model. In the short run, the economy must move from A to B , with a fall in wealth from ¯ W 0 to W 1 and an increase in the real exchange rate from ¯ Q 0 to Q 1 . This is because point B represents the only position of short-run equilibrium that is consistent with the perfect foresight path that converges on the new steady-state equilibrium at point C . As the level of wealth falls from ¯ W 0 to W 1 , the real exchange rate must rise from ¯ Q 0 to Q 1 , leading to real exchange rate Overshooting relative to the value determined by long-run equilibrium (that is, Q 1 > ¯ Q 0 ). However, the economy cannot settle at B , because it must move to C in the long run.
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