Economics Exchange Rate Systems Questions Medium
Exchange rate overshooting refers to a phenomenon in which the exchange rate of a currency temporarily moves beyond its long-term equilibrium level before eventually returning to a more stable position. Several factors contribute to exchange rate overshooting:
1. Interest rate differentials: Differences in interest rates between countries can lead to capital flows seeking higher returns. If a country raises its interest rates, it attracts foreign investors who seek higher yields. This increased demand for the currency can cause an overshooting of the exchange rate.
2. Speculation and market sentiment: Expectations and perceptions of future exchange rate movements can influence short-term currency demand. Speculators may anticipate future exchange rate movements and engage in trading activities that amplify the overshooting effect.
3. Macroeconomic imbalances: Economic factors such as inflation, fiscal deficits, and current account imbalances can impact exchange rates. If a country experiences high inflation or a large current account deficit, it may lead to a depreciation of its currency, causing an overshooting effect.
4. Government intervention: Central banks and governments can influence exchange rates through intervention in the foreign exchange market. If a government actively intervenes to stabilize its currency, it can cause an overshooting effect if the market perceives the intervention as temporary or unsustainable.
5. External shocks: Unexpected events such as natural disasters, political instability, or changes in global economic conditions can lead to exchange rate overshooting. These shocks can disrupt the normal functioning of currency markets and cause significant short-term fluctuations in exchange rates.
It is important to note that exchange rate overshooting is a temporary phenomenon, and over time, the exchange rate tends to converge towards its long-term equilibrium level as market forces adjust.