Overshooting

Overshooting

What is overshooting?

Overshooting (the exchange rate overshooting hypothesis) explains why currency exchange rates can be much more volatile than goods prices. It attributes this volatility to “sticky” goods prices that adjust slowly, while financial prices—particularly exchange rates and interest rates—respond quickly to shocks such as changes in monetary policy.

Key points

• Exchange rates can temporarily overreact to shocks because goods prices are slow to adjust (price stickiness or nominal rigidity).
• Financial markets reach short-run equilibrium quickly; goods markets adjust more slowly, causing a temporary imbalance that exchange rates correct by moving beyond their long-run level.
• As goods prices gradually adjust, exchange rates move back toward their long-run equilibrium.

Origin and significance

Rüdiger Dornbusch introduced the overshooting model in his 1976 paper “Expectations and Exchange Rate Dynamics.” The model applied rational expectations and highlighted how differences in adjustment speeds between financial and goods markets produce pronounced short-run exchange rate volatility. It is considered foundational in modern international macroeconomics and helped explain observed volatility during the shift from fixed to floating exchange rates.

How the model works (mechanism)

1. A monetary policy shock occurs (e.g., a change in nominal money supply or interest rates).
2. Financial markets react immediately: asset prices and interest rates adjust quickly.
3. Goods prices, however, are sticky and do not adjust right away.
4. To restore short-run equilibrium given sticky goods prices and uncovered interest parity, the exchange rate moves more than its long-run change—this is the overshoot.
5. Over time, goods prices adjust (menu costs, information delays, nominal rigidity), and the exchange rate gradually returns to its long-run equilibrium.

What “sticky” means

Price stickiness (nominal rigidity) means some prices change slowly in response to market conditions. Causes include menu costs (the cost of changing prices), contractual arrangements, and delays in observing changes in production costs. Stickiness prevents goods prices from instantaneously reflecting new monetary conditions, which is central to the overshooting phenomenon.

Implications and considerations

• Overshooting explains why exchange rates display greater short-run volatility relative to goods prices.
• The model relies on rational expectations and different adjustment speeds across markets; both assumptions have empirical support.
• It is especially relevant in economies with floating exchange rates and during periods of large monetary shocks.
• While influential, the model abstracts from many real-world frictions; extensions and empirical tests consider additional factors such as staggered price setting, capital controls, and market microstructure.

Bottom line

Overshooting describes how exchange rates can temporarily move beyond their long-run equilibrium in response to shocks because financial markets adjust quickly while goods prices remain sticky. As goods prices slowly catch up, exchange rates correct, producing the high short-run volatility observed in foreign-exchange markets.

Further reading

• R. Dornbusch, “Expectations and Exchange Rate Dynamics,” Journal of Political Economy, 1976.
• International Monetary Fund, “Dornbusch’s Overshooting Model After Twenty-Five Years.”