Economics Exchange Rates Questions Medium
Exchange rate overshooting is a concept in economics that describes the phenomenon where the exchange rate of a currency temporarily moves beyond its long-term equilibrium level in response to certain shocks or changes in the economy. This theory was developed by economist Rudiger Dornbusch in the 1970s.
According to the theory, when there is a sudden change in economic conditions, such as a change in interest rates, government policies, or expectations about future economic performance, the exchange rate tends to adjust more in the short run than it would in the long run. This means that the exchange rate "overshoots" its long-term equilibrium level before eventually moving back towards it.
The reason behind this overshooting is the presence of sticky prices and imperfect information in the economy. In the short run, prices of goods and services may not adjust immediately to reflect changes in exchange rates. Additionally, market participants may not have perfect information about the true value of a currency, leading to speculative behavior and exaggerated movements in the exchange rate.
For example, if a country's central bank raises interest rates to combat inflation, this action may attract foreign investors seeking higher returns. As a result, the demand for the country's currency increases, causing its exchange rate to appreciate. However, due to sticky prices and imperfect information, the exchange rate may appreciate more than what is justified by the fundamental economic factors. This overshooting can lead to short-term volatility and potential misalignments between the exchange rate and its long-term equilibrium level.
Over time, as prices adjust and market participants gain more information, the exchange rate gradually moves back towards its long-term equilibrium level. This adjustment process can be influenced by factors such as trade flows, capital flows, and market expectations. Eventually, the exchange rate settles at a level that reflects the underlying economic fundamentals.
In summary, exchange rate overshooting is a temporary phenomenon where the exchange rate moves beyond its long-term equilibrium level in response to economic shocks or changes. It occurs due to sticky prices and imperfect information in the economy, and the exchange rate eventually adjusts back towards its long-term equilibrium level as prices and information become more accurate.