What Is Overshooting?
Key takeaways
– Overshooting (the exchange-rate overshooting hypothesis) explains why nominal exchange rates can react more strongly and more quickly to monetary shocks than goods prices do.
– The idea was formalized by Rüdiger Dornbusch (1976): because goods prices are “sticky” in the short run but financial prices and expectations adjust quickly, the nominal exchange rate temporarily “overshoots” its long‑run value.
– Overshooting helps explain high short‑run volatility in FX markets and implies predictable transitional dynamics: large immediate moves in the exchange rate followed by gradual reversal as goods prices adjust.
– Practical implications differ by audience: policymakers (manage expectations, coordinate policy), traders (watch interest differentials, hedge), and researchers (test models and microfoundations).
Understanding overshooting
The overshooting concept links three elements:
1. Fast‑moving financial prices: exchange rates and interest rates adjust nearly instantaneously to news and policy changes.
2. Sticky goods prices (nominal rigidities): consumer and producer prices tend to change slowly because of menu costs, contracts, adjustment costs, measurement lags, and other frictions.
3. Rational expectations and uncovered interest parity (UIP): investors form expectations about future exchange rates, and expected returns across currencies are linked to interest differentials.
Mechanically, a monetary expansion (higher money supply) lowers domestic nominal interest rates. Under UIP, the expected future depreciation of the domestic currency must rise to keep returns aligned; with sticky prices, the required adjustment cannot occur through immediate changes in domestic goods prices, so the nominal exchange rate must depreciate by more than the eventual long‑run change (it “overshoots”). Over time, as domestic goods prices rise (catch up), the exchange rate appreciates back toward its long‑run equilibrium.
Important: what “stickiness” means in economics
“Sticky” (nominal rigidity) refers to sluggish adjustment of nominal prices or wages to changes in supply and demand. Reasons for stickiness include:
– Menu costs (real costs of changing price lists),
– Long‑term contracts or wage agreements,
– Uncertainty about persistence of shocks,
– Costs of reoptimizing production and distribution,
– Information and coordination problems.
The Overshooting Model (Dornbusch 1976) — core logic
– Setup: small open economy with flexible nominal exchange rate, sticky domestic goods prices, perfect capital mobility, rational expectations.
– Short run: goods prices fixed, money shock changes interest rates and expectations; financial assets clear markets, so the nominal exchange rate moves sharply (overshoots).
– Long run: goods prices gradually adjust, real variables settle, and the nominal exchange rate moves back to a new long‑run level implied by monetary fundamentals.
Why this matters
– Explains why exchange rates are typically far more volatile than relative prices of traded goods.
– Clarifies transitional dynamics after policy shocks: large immediate FX responses followed by slow mean reversion.
– Emphasizes the central role of expectations and monetary policy credibility in exchange‑rate dynamics.
Special considerations and limitations
– Empirical tests: many studies find evidence consistent with overshooting, but real‑world dynamics also include risk premia, capital controls, market frictions, and behavioral elements that depart from the pure model.
– UIP often fails empirically (the “forward premium puzzle”): expected depreciation does not always offset interest differentials, suggesting time‑varying risk premia or limits to arbitrage.
– Microfoundations: more modern models embed nominal rigidities within general equilibrium frameworks (DSGE) and allow for heterogeneous agents, financial frictions, and imperfect pass‑through.
– Regime dependence: overshooting logic is most applicable under flexible exchange rates and high capital mobility; under fixed rates or capital controls the dynamics differ.
What causes volatility in exchange rates (beyond overshooting)?
– Monetary policy shocks and shifts in policy expectations.
– Large capital flows, sudden stops, or changes in risk appetite.
– News surprises: macro data, geopolitical events, central bank guidance.
– Speculative flows and market microstructure (liquidity shortages, order imbalance).
– Differences in inflation expectations and risk premia.
Practical steps — how to apply overshooting insights
For policymakers
1. Communicate clearly and anchor expectations:
– Provide forward guidance and credible policy frameworks (e.g., inflation targeting) to reduce unnecessary overshooting driven by shifting expectations.
2. Consider the pace of policy adjustment:
– Gradual moves reduce the scope for large instantaneous FX reactions; abrupt policy changes are more likely to trigger overshooting.
3. Use a mix of tools when appropriate:
– In extreme episodes, temporary FX intervention or liquidity provision can limit disruptive overshooting, but interventions have limits and costs.
4. Coordinate fiscal and monetary policy:
– Fiscal surprises can undermine monetary control and amplify exchange‑rate volatility; coordination reduces unexpected imbalances.
5. Monitor capital flow and banking sector vulnerabilities:
– Macroprudential measures can lower the odds that exchange rate swings transmit into financial instability.
For FX traders and portfolio managers
1. Monitor key indicators:
– Central bank announcements, short‑term rate expectations, inflation and wage data, and measures of market liquidity.
2. Watch interest differentials and forward rates:
– Changes in policy and the forward curve can signal expected FX trajectories consistent with overshooting dynamics.
3. Manage risk (hedging and position sizing):
– Use stops, options, or dynamic hedging to protect against sharp overshoot moves and subsequent reversals.
4. Be cautious with carry trades:
– Carry strategies (borrow low‑rate currency, lend high‑rate currency) can suffer large losses if the funding currency overshoots on policy surprises.
5. Use event‑driven strategies:
– Recognize that policy events often produce the largest short‑run moves; prepare liquidity and clear trade plans for those windows.
For students and researchers
1. Read the classics and follow‑ups:
– Dornbusch, R. (1976) “Expectations and Exchange Rate Dynamics,” Journal of Political Economy. (Foundational model.)
– IMF, “Dornbusch’s Overshooting Model After Twenty‑Five Years” (survey of developments and empirical evidence).
2. Build and simulate simple models:
– Start with a small open economy with sticky prices and rational expectations, simulate monetary shocks and trace transitional dynamics.
3. Test empirically:
– Use VARs, event studies, and panel regressions to detect overshooting patterns after monetary shocks.
4. Explore extensions:
– Incorporate risk premia, financial frictions, heterogeneous agents, or sticky wages into models to better match data.
What is the bottom line?
Overshooting explains why exchange rates often move more than goods prices immediately after monetary shocks: financial markets adjust fast and expectations force a large initial move, whereas goods prices adjust slowly. This creates predictable transitional behavior—large short‑term FX moves followed by gradual correction—that has important consequences for policy, risk management, and trading. While the Dornbusch model is a compact and influential framework, real‑world FX volatility also reflects risk premia, market structure, and other frictions that go beyond the original model.
Sources and further reading
– Dornbusch, R. (1976). “Expectations and Exchange Rate Dynamics.” Journal of Political Economy, 84(6), 1161–1176.
– International Monetary Fund. “Dornbusch’s Overshooting Model After Twenty‑Five Years.” (Survey paper reviewing developments and evidence.)
– Investopedia. “Overshooting.” (Introductory overview and practical explanation.)
Recap and bridge from previous discussion
You’ve already seen the core idea: Dornbusch’s overshooting model explains why exchange rates can react more strongly and more quickly to monetary shocks than goods prices do. Financial prices (like exchange rates) move rapidly; goods prices are “sticky” (adjust slowly). The combination of rational expectations and sticky goods prices implies that exchange rates must temporarily move past their long-run equilibrium (overshoot) so that interest-rate differentials and expected future exchange-rate paths are consistent.
Below I continue with deeper intuition, a simple sketch of the model mechanics, illustrative examples, practical steps for different economic actors, empirical evidence and limitations, and a concise summary.
A simple, intuitive sketch of the mechanics
– Starting point: long-run equilibrium where purchasing-power parity (PPP) or some real equilibrium holds and interest rates reflect expected inflation and risk premia.
– Monetary shock: the central bank unexpectedly increases (or decreases) the monetary base.
– Immediate financial-market response: money supply increase → lower short-term nominal interest rate (i) relative to the foreign rate (i*). Under uncovered interest parity (UIP) and rational expectations, foreign and domestic assets must offer expected returns that are equalized. If domestic rates fall, investors will only accept lower short-term yields if they expect the domestic currency to appreciate in the future. That implies an expected future depreciation of the exchange rate must exist.
– Why overshooting? Because goods prices are sticky, they cannot immediately rise to the new equilibrium that matches the increased money supply. If prices cannot adjust, the real money supply is higher today than in the long run. To restore equilibrium in asset markets immediately, the nominal exchange rate must jump beyond its long-run change (i.e., depreciate further) so that expected future appreciation (as goods prices slowly rise) compensates investors for the lower interest rate today.
– Gradual adjustment: as prices slowly rise (reducing real money balances toward their long-run level), the exchange rate appreciates from its overshot level toward the new long-run equilibrium.
How the textbook model links the variables (nontechnical)
– Uncovered interest parity (UIP) roughly says: domestic interest rate − foreign interest rate ≈ expected rate of depreciation of the domestic currency.
– PPP (in the long run) links exchange rates to price levels across countries.
– Sticky goods prices break the immediate PPP adjustment; financial markets satisfy UIP quickly. The combination forces the exchange rate to do much of the short-run adjustment.
A compact numerical illustration (hypothetical)
– Pre-shock: domestic exchange rate = 1.00 domestic currency per foreign currency; domestic interest rate i = 5%; foreign i* = 5%; expected future depreciation = 0 (steady state).
– Monetary expansion: central bank lowers domestic i to 2% (unexpected).
– Under UIP, investors require an expected annual depreciation of (i − i*) = −3% (i.e., expected appreciation) to hold domestic bonds. But because i fell and goods prices are sticky, the exchange rate immediately depreciates say by 10% to 1.10. Why so large? Because that immediate depreciation creates an expected path where the currency will appreciate over time (from 1.10 back toward roughly 1.05 then 1.00), giving investors the expected capital gains needed to offset the lower interest rate.
– Over months and years, prices adjust upward (real money balances fall), and the exchange rate slowly appreciates from 1.10 back toward its new long-run level (maybe 1.05 or 1.00 depending on the inflation effect).
Real-world examples and episodes (qualitative)
– The model was developed in the 1970s when many economies transitioned from fixed to floating exchange rates and when monetary shocks and volatile exchange-rate movements were common. Dornbusch’s framework helped explain why the dollar and other currencies showed large, rapid swings on monetary news.
– Typical historical pattern consistent with overshooting: an unexpected tightening of monetary policy (higher rates) leads to an immediate currency appreciation beyond its eventual level, followed by gradual depreciation as domestic goods prices fall or adjust downward.
– Many episodes of large short-run FX moves around central-bank announcements, crises, or sudden reversals in monetary stance can be interpreted in the light of the overshooting idea. However, actual episodes are affected by capital controls, risk-premium changes, market microstructure, and policy signaling, so attributing every swing to Dornbusch overshooting alone is simplistic.
Empirical evidence and what studies find
– Empirical work finds that exchange rates are more volatile and more responsive to monetary policy than goods prices, consistent with the overshooting intuition.
– However, precisely measuring overshooting in data is difficult because:
– It requires identifying exogenous monetary shocks.
– Prices adjust at different speeds across sectors and countries.
– Risk premia and expectations can change for reasons other than monetary policy.
– Reviews of the literature (including IMF retrospectives on Dornbusch’s work) conclude that while the original model is stylized, its core insight—fast-moving asset prices vs. slow-moving goods prices—remains a central organizing principle in international macroeconomics.
Practical steps and implications
For policymakers
– Communicate policy aims clearly and credibly. Surprise monetary moves are more likely to trigger sharp overshooting. Better forward guidance reduces unnecessary volatility by aligning expectations.
– Consider the interaction of monetary policy with exchange-rate dynamics, especially in small open economies where FX moves have big effects on inflation and output.
– If excessive short-term volatility is harmful (e.g., disrupting trade finance), use a combination of macroprudential tools, FX intervention, or temporary capital-flow measures—recognizing these have costs.
– Monitor and manage risk premia. Sometimes FX swings reflect changing risk perceptions rather than only the adjustment of relative money supplies.
For exporters and importers
– Hedge key exposures. Use forwards, futures, options, or natural hedges (matching currency denominations of costs and revenues).
– When entering contracts, consider shorter invoicing horizons or clauses that share FX risk.
– Monitor central-bank signals and macro indicators—overshooting is more likely around big policy surprises.
For investors and portfolio managers
– Be cautious drawing inference that an immediate FX move is the long-run valuation; the exchange rate may partially reverse as goods prices and fundamentals adjust.
– Use hedging strategies calibrated to expected time to mean reversion and the firm’s risk tolerance.
For firms setting prices (managers)
– Recognize how sticky pricing strategies (menu costs, contracts, local competition) affect pass-through between FX moves and local prices.
– Plan for temporary FX-driven earnings volatility; model scenarios with overshoot and subsequent partial reversal.
Special considerations, caveats, and model limitations
– The original Dornbusch model is highly stylized. It assumes:
– Perfect capital mobility (so UIP is relevant).
– Rational, homogeneous expectations.
– One-period sticky nominal goods prices (or stickiness that works in a simple way).
– Real-world deviations:
– Risk premia and liquidity premia can change, altering the UIP link.
– Price stickiness varies across sectors—some consumer prices are flexible, others are sticky.
– Central-bank credibility, capital controls, and macroprudential regulations can weaken the simple mechanism.
– Expectations are not always perfectly rational or homogeneous; learning, bounded rationality, or market frictions can change dynamics.
– Extensions of the model incorporate stochastic shocks, nominal rigidities of different types, and microfoundations for price stickiness (sticky wages, staggered contracts, menu costs).
Worked numerical scenario (more explicit)
– Suppose a small open economy initially has:
– Exchange rate S0 = 1.00 (domestic currency per unit of foreign currency).
– Domestic nominal interest rate i0 = 6%; foreign i* = 6%.
– Long-run effect of a permanent monetary expansion is expected to raise the domestic price level by 10% relative to foreign prices (so long-run exchange rate should be 1.10).
– If money supply unexpectedly increases today and the domestic short-term nominal rate falls to 3%, rational expectations + UIP imply investors will demand expected appreciation in the future to hold domestic assets. Because prices are sticky now, the exchange rate must jump beyond 1.10—say to 1.20—so that the expected future appreciation from 1.20 back toward 1.10 (or toward 1.00 depending on assumptions) compensates investors for the lower interest rate. Over time, as price levels rise by 10%, the exchange rate will appreciated from 1.20 toward its new long-run value (e.g., 1.10).
Policy-relevant extensions and modern perspectives
– Microfounded sticky-price models (Calvo pricing, staggered contracts) and general equilibrium DSGE models incorporate Dornbusch-style dynamics within richer frameworks. They often reach similar qualitative conclusions about fast asset adjustment vs. slow nominal price adjustment.
– Behavioral and market-friction models emphasize that expectations formation, limited arbitrage, and liquidity constraints can make overshooting larger—or change its timing.
– Exchange-rate pass-through to import prices, inflation, and output depends on the degree of price stickiness, market structure, and monetary-policy regimes.
Concluding summary
– Overshooting is a central idea in international macroeconomics: when monetary policy changes, exchange rates can temporarily move beyond their long-run equilibrium because financial markets adjust quickly while goods prices adjust slowly (price stickiness).
– Dornbusch’s 1976 model provided a parsimonious way to explain observed high exchange-rate volatility and has shaped decades of research and policy thinking.
– The model’s policy and practical implications are important: surprise monetary moves can generate large short-term currency swings, which affect trade, inflation, and corporate earnings. Policymakers, firms, and investors can mitigate risk through communication, hedging, and careful planning.
– The core insight (fast-moving asset prices vs. slow-moving goods prices) remains robust, but empirical application requires attention to risk premia, capital controls, sectoral differences in price flexibility, and the structure of expectations.
Further reading and sources
– Dornbusch, Rüdiger. “Expectations and Exchange Rate Dynamics.” Journal of Political Economy, 1976, pp. 1161–1176.
– International Monetary Fund. “Dornbusch’s Overshooting Model After Twenty-Five Years.” (IMF staff/retrospective piece). See IMF archives for the paper and discussion; includes commentary on rational expectations and the model’s legacy.
– Investopedia. “Overshooting.” https://www.investopedia.com/terms/o/overshooting.asp
– For modern macroeconomic formalizations and extensions, see graduate textbooks on international macroeconomics and DSGE modeling that discuss nominal rigidities and exchange-rate dynamics.
Editor’s note: The following topics are reserved for upcoming updates and will be expanded with detailed examples and datasets.
[[END]]