Exchange Rate Overshooting

Question 1

What is exchange rate overshooting?

Answer 1

The phenomenon that exchange rates (both real and nominal), jump more than the equilibrium adjustment in response to shocks.

Question 2

What causes overshooting?

Answer 2

1. An internationally integrated forex market.
2. Rational Expectations in the forex market (so UIP condition always holds).
3. Sticky wages and prices. This requires:
   - r < r* until target
   inflation when negative
   AD shock
   - r > r* until target
   inflation when
   positive AD shock

Question 3

UIP condition and Overshooting

Answer 3

The larger the shock, the greater the interest differential rt - r* that is needed to restore equilibrium.

The larger the real interest differential, the more that the real exchange rate will overshoot.

Question 4

Initial exchange rate jump

Answer 4

equilibrium change + exchange rate overshooting.

Question 5

How do nominal and real exchange rates differ in overshooting?

Answer 5

Following an inflation shock, the initial nominal appreciation will be less than the real appreciation. This is because the inflation shock produced some of the required real exchange rate appreciation.

During adjustment however, nominal depreciation will exceed real depreciation. Real depreciation is pinned down by real UIP. Nominal depreciation is greater in order to offset the real appreciation due to P rising.