Overshooting

Overshooting may occur for a host of economic variables. Depending upon the concerned mode of analysis overshooting of key variables has different implications for an economy. One prime model of overshooting analysis is that of exchange rate determination. (Dornbusch’s overshooting hypothesis has received much critical acclaim in economic circles). Some empirical analysis suggests that real exchange rate overshooting after currency crises assumes serious dimensions in nations with high volumes of foreign debt. Here overshooting phenomenon is associated with massive output contractions, which has far-reaching results for the economy in concern. Financial distortions resulting from margin constraints and lack of hedging results in overshooting of asset prices as well as real exchange rates under regimes of flexible exchange rates during a crisis. Margin constraint results in a rapid sale of assets in a bid to diminish exposure to foreign currency liability. This results in a negative wealth effect, which affects long-term welfare and consumption in an adverse way. This kind of real exchange rate overshooting is absent in a fixed exchange rate regime. This contains equity price overshooting. This however later leads to a bigger short-run contraction.

Dornbusch’s Overshooting Hypothesis

Rudiger Dornbusch propagated his famous exchange rate overshooting hypothesis in 1976. Here a simplified overview of Dornbusch’s overshooting hypothesis is attempted. This theory postulates that currencies are inherently volatile. Hence they are susceptible to ‘overshooting’ or going up or below their expected ranges. According to this proposition, there occurs an instant appreciation of nominal exchange rates with an increment in nominal rates of interest. This conforms to uncovered interest parity (UIP). However, some recent empirical studies have brought out contradictory results.

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