Overshooting describes an economic scenario where certain variables exceed their long-run equilibrium in response to a shock, due to differing adjustment speeds of various economic factors. It is a concept particularly relevant to exchange rates, where the initial impact of a shock may cause the exchange rate to fluctuate more dramatically before stabilizing at its new equilibrium.
Historical Context
The concept of overshooting was prominently developed by economist Rudi Dornbusch in the 1976 paper titled “Expectations and Exchange Rate Dynamics.” Dornbusch’s model explained how exchange rates could overshoot their long-term values due to sticky prices and instantaneous adjustments in financial markets compared to slower adjustments in goods markets.
Types/Categories
Exchange Rate Overshooting
This is the most studied type of overshooting where an exchange rate initially moves past its long-run equilibrium in response to monetary policy changes or other economic shocks.
Interest Rate Overshooting
When an economic shock, such as a change in monetary policy, causes interest rates to temporarily exceed their long-term values.
Key Events and Detailed Explanations
Dornbusch Model
The Dornbusch Overshooting Model explains why exchange rates can overshoot. The model is based on two main assumptions:
- Prices of goods are sticky in the short run.
- Financial markets adjust instantly to changes in economic policies or conditions.
Mathematical Formula
The Dornbusch model can be represented using the following key equations:
- Uncovered Interest Parity (UIP):
$$ E_t(s_{t+1}) - s_t = i_t - i_t^* $$
- Sticky Price Assumption:
$$ p_t = p_{t-1} + \alpha (y_t - y_t^*) $$
Where:
- \(E_t(s_{t+1})\) is the expected future spot exchange rate.
- \(s_t\) is the current spot exchange rate.
- \(i_t\) is the domestic interest rate.
- \(i_t^*\) is the foreign interest rate.
- \(p_t\) and \(p_{t-1}\) are current and previous price levels.
- \(y_t\) and \(y_t^*\) are current and natural output levels, respectively.
Adjustment Process Chart (Mermaid Diagram)
graph TD
A[Shock to Economy] --> B[Initial Market Reaction]
B --> C[Rapid Adjustment in Financial Markets]
C --> D[Overshoot in Variable]
D --> E[Gradual Adjustment in Goods Markets]
E --> F[New Long-term Equilibrium]
Importance and Applicability
Overshooting is crucial for understanding the dynamics of financial markets and the impact of policy changes. It helps policymakers anticipate and manage the short-term volatility that follows economic shocks.
Examples
Example 1: Exchange Rate Overshooting
When the central bank unexpectedly raises interest rates, the local currency might appreciate significantly. However, this initial rise might be more than required for the new equilibrium, eventually correcting downwards.
Example 2: Commodity Prices
A sudden increase in oil demand might cause prices to spike dramatically before settling at a new higher equilibrium.
Considerations
Risks
- Volatility: Overshooting can cause high volatility in financial markets.
- Policy Implementation: Policymakers must consider overshooting effects when designing and implementing policy measures.
Related Terms
- Uncovered Interest Parity (UIP): A condition stating that the difference in interest rates between two countries is equal to the expected change in exchange rates.
- Sticky Prices: The resistance of prices to change immediately in response to economic shocks.
- Exchange Rate Dynamics: The study of how exchange rates move over time in response to various factors.
Comparisons
Overshooting vs Undershooting
- Overshooting: Variables exceed their long-run equilibrium in the short term.
- Undershooting: Variables do not fully adjust to their new equilibrium in the short term.
Interesting Facts
- Dornbusch’s paper is one of the most cited papers in international economics.
- The overshooting model has been validated by various empirical studies across different economic contexts.
Inspirational Stories
Story: The Central Bank’s Tactical Overshoot
In 1980, the Federal Reserve raised interest rates sharply to curb inflation. The U.S. dollar initially overshot its value but eventually stabilized, leading to long-term economic stability.
Famous Quotes
- “Markets can remain irrational longer than you can remain solvent.” — John Maynard Keynes
- “Expect the unexpected and take advantage of what overshooting presents.” — Unknown
Proverbs and Clichés
- “Too much of a good thing.”: Reflects the essence of overshooting when adjustments surpass necessity.
- “Don’t overreact.”: Often used in the context of overshooting in financial markets.
Expressions, Jargon, and Slang
- “Spike”: A sudden, sharp increase in price or value.
- [“Whipsaw”](https://financedictionarypro.com/definitions/w/whipsaw/ ““Whipsaw””): Market conditions where prices swing back and forth unpredictably, often associated with overshooting.
FAQs
Q1: What causes overshooting?
Q2: How can overshooting be mitigated?
Q3: Is overshooting a permanent state?
References
- Dornbusch, R. (1976). “Expectations and Exchange Rate Dynamics”. Journal of Political Economy.
- Frankel, J. A. (1979). “On the Mark: A Theory of Floating Exchange Rates Based on Real Interest Differentials”. American Economic Review.
Summary
Overshooting is an economic phenomenon where variables exceed their long-run equilibrium following a shock due to differing adjustment speeds of economic factors. Understanding and anticipating overshooting effects are vital for policymakers to manage short-term volatility and achieve long-term economic stability.
