Exchange Rates
Overshooting

A characteristic of many models of the exchange rate is that the foreign exchange market is fully efficient in processing information. Following any disturbance or new information, the exchange rate jumps instantaneously to maintain equilibrium in the asset market. Where these models differ most is in their assumption about the speed of adjustment of goods prices; these range from zero to infinite. In between lie the sticky price models of Dornbusch and others, in which, immediately following a disturbance, the price level remains unchanged but the exchange rate jumps to clear the asset market. Subsequently goods prices begin to adjust, enabling the exchange rate to proceed to its equilibrium value along the perfect foresight path. The new equilibrium will depend on the type and permanence of the disturbance. For example, a permanent increase in the money stock would cause both the equilibrium price level and the exchange rate - the domestic price of foreign exchange - to increase. The initial jump takes the exchange rate beyond its new equilibrium level, however, hence the description of these models as 'overshooting' models.

The best known overshooting model is that of Dornbusch, which has proved a very influential alternative to the monetary model. Dornbusch's analysis is carried out in continuous time and with the assumption of perfect foresight. This is not a convenient framework for empirical work using, for example, quarterly data.

With this in mind, CEPR Research Fellow Mike Wickens respecifies Dornbusch's model in discrete time, with rational expectations. Using a different method of analysis from that customarily employed in solving rational expectations models, Wickens examines the conditions under which the exchange rate will overshoot and the nature of its adjustment path. He also examines the effect of announcements on the exchange rate.

He finds that price stickiness is neither a necessary nor a sufficient condition for monetary policy to bring about exchange rate overshooting. Moreover, the behaviour of the exchange rate in this model can be interpreted as a 'partial adjustment' mechanism, in which the exchange rate will change from one period to the next by a certain proportion of its distance from long-run equilibrium. Wickens argues that this approach gives a better understanding of how the exchange rate moves in anticipation of changes in exogenous variables such as monetary and fiscal policy instruments.


Rational Expectations and Exchange Rate Dynamics
M R Wickens

Discussion Paper No. 20, June 1984 (IM)