CandleFocus Glossary Editor
Overshooting is a theory that describes how an economy reacts to changes in the exchange rate. The model was developed by economists, Robert Mundell and Marcus Fleming in 1961 and has since become an important part of an economists toolkit. The model suggests that, when foreign exchange rates change, there is a short-term trade-off between the immediate exchange rate and the future prices of goods.
This trade-off is due to the fact that the prices of goods usually do not immediately react to a change in foreign exchange rates. Instead, the overshooting model hypothesizes that a domino effect first impacts other factors—such as financial markets, money markets, derivatives markets, and bond markets—which then transfers its influence onto the prices of goods. Through this mechanism, it is postulated that exchange rate changes have a long-term effect on the price of goods in an economy, even when the initial effects of exchange rate changes are reversed.
The model suggests that higher exchange rate values temporarily aim to raise prices of goods more than is normally expected in a non-interventionist economy, and that prices eventually overshoot the level that is expected based on money supply and demand - hence the term 'Overshooting'. This phenomenon is thought to be as a result of 'sticky' or inflexible prices, which hinder the immediate response to the exchange rate changes. This induces a lengthy process of adapting to the new price equilibrium, creating a process of overshooting.
Essentially, the overshooting model suggests that domestic prices are affected by foreign exchange rate changes over the long-term, and that sticky prices, economic fundamentals and other factors play a varying degree of influence in the process. It is a useful tool for economists to form hypotheses regarding the international monetary system, and to pinpoint the effects that a change in exchange rate could have on domestic prices.
This trade-off is due to the fact that the prices of goods usually do not immediately react to a change in foreign exchange rates. Instead, the overshooting model hypothesizes that a domino effect first impacts other factors—such as financial markets, money markets, derivatives markets, and bond markets—which then transfers its influence onto the prices of goods. Through this mechanism, it is postulated that exchange rate changes have a long-term effect on the price of goods in an economy, even when the initial effects of exchange rate changes are reversed.
The model suggests that higher exchange rate values temporarily aim to raise prices of goods more than is normally expected in a non-interventionist economy, and that prices eventually overshoot the level that is expected based on money supply and demand - hence the term 'Overshooting'. This phenomenon is thought to be as a result of 'sticky' or inflexible prices, which hinder the immediate response to the exchange rate changes. This induces a lengthy process of adapting to the new price equilibrium, creating a process of overshooting.
Essentially, the overshooting model suggests that domestic prices are affected by foreign exchange rate changes over the long-term, and that sticky prices, economic fundamentals and other factors play a varying degree of influence in the process. It is a useful tool for economists to form hypotheses regarding the international monetary system, and to pinpoint the effects that a change in exchange rate could have on domestic prices.