Question

In the discussion of exchange rate overshooting, we assumed that the price level (P) was sticky in the short run. Explain why overshooting could not occur if the price level could immediately jump to the long-run equilibrium value consistent with the higher money supply.

Answer 1

Overshooting model was first developed by German economist Rudi Dornbusch, and it is a theoretical explanation for high levels of exchange rate volatility.

According to the exchange rate overshooting hypothesis, when a change in monetary policy occurs (e.g., an unanticipated permanent increase in the money supply), the market will adjust to a new equilibrium between prices and quantities. Initially, because of the "stickiness" of prices of goods, the new short run equilibrium level will first be achieved through shifts in financial market prices.

Then, gradually, as prices of goods "unstick" and shift to the new equilibrium, the foreign exchange market continuously reprices, approaching its new long-term equilibrium level. Only after this process has run its course will a new long-run equilibrium be attained in the domestic money market, the currency exchange market, and the goods market.

As a result, the foreign exchange market will initially overreact to a monetary change, achieving a new short run equilibrium. Over time, goods prices will eventually respond, allowing the foreign exchange market to dissipate its overreaction, and the economy to reach the new long run equilibrium in all markets.

If the price level could immediately jump to the long-run equilibrium value which is consistent with higher money supply, due to rational expectation people will expect the prices to go that higher and thus they will be prepared to accommodate to the new market condition. Thus there would be no volatility in the exchange rate.