The Overshooting Hypothesis is a theoretical model in economics proposed by economist Rudiger Dornbusch in 1976. It addresses the phenomenon where exchange rates exhibit greater short-term volatility than long-term expectations would suggest. This model is highly influential in explaining the immediate and often exaggerated response of exchange rates to changes in monetary policy.
Mechanics of Overshooting
Core Principles
According to the hypothesis, when a country changes its monetary policy, the impact on exchange rates can be immediate and significant due to differences in the adjustment speeds of financial markets and goods markets. Financial markets, which adjust quickly, react more intensely compared to more sluggish goods markets.
Mathematical Representation
The key insight of the model is represented by the adjustment dynamics:
- \(E\) = nominal exchange rate
- \(E^*\) = natural level of exchange rate
- \(M\) = money supply
- \(P\) = price level
- \(\epsilon\) = elasticity parameter
Historical Context of the Hypothesis
Rudiger Dornbusch’s theory was developed during a period of significant economic turbulence, including the breakdown of the Bretton Woods system and subsequent floating exchange rates. The hypothesis helps to understand and explain the exchange rate volatility observed during this era.
Applicability
This model is particularly useful for policymakers and economists engaged in formulating and assessing monetary policy, as it provides a framework for predicting the immediate effects of policy changes on exchange rates. It is also valuable for investors who need to anticipate currency movements.
Special Considerations
Assumptions
The hypothesis assumes perfect capital mobility and rational expectations. It also presumes that adjustments in the financial markets are instantaneous, while goods markets take time to adjust.
Examples and Implications
To illustrate, consider a situation where the central bank increases the money supply. According to the Overshooting Hypothesis, the exchange rate will initially depreciate more than it will in the long-term, before adjusting to its new equilibrium.
FAQs about the Overshooting Hypothesis
What is overshooting in exchange rates?
- Overshooting is when the exchange rate reacts more drastically in the short-term than the long-term equilibrium would suggest, usually in response to a change in monetary policy.
Why is the Overshooting Hypothesis important?
- It is crucial because it helps explain the high short-term volatility of exchange rates, which is not accounted for by traditional models.
Who proposed the Overshooting Hypothesis?
- The hypothesis was proposed by economist Rudiger Dornbusch in 1976.
Related Terms
- Exchange Rate Volatility: The degree of variation of an exchange rate over time.
- Monetary Policy: Actions by a central bank to manage money supply and interest rates.
- Floating Exchange Rates: Exchange rates determined by market forces without direct government or central bank intervention.
References
- Dornbusch, R. (1976). Expectations and Exchange Rate Dynamics. Journal of Political Economy.
- Krugman, P., & Obstfeld, M. (2003). International Economics: Theory and Policy. Pearson Education.
Summary
The Overshooting Hypothesis is a pivotal model in economics that explains the disproportionately high volatility of exchange rates in response to changes in monetary policy. By understanding the differential adjustment speeds between financial and goods markets, this hypothesis provides essential insights for policymakers, economists, and investors alike.
