Exchange rate overshooting occurs in response to shocks from "summary" of International Money and Finance by Michael Melvin
When shocks hit an economy, exchange rates tend to overshoot. This phenomenon can be explained by the adjustment process that exchange rates go through in response to unexpected events. Shocks can come in many forms, such as changes in interest rates, inflation rates, or political events. Exchange rates are influenced by a variety of factors, including interest rate differentials, trade balances, and overall economic conditions. When a shock occurs, these factors are suddenly disrupted, causing exchange rates to move in a direction that may seem excessive at first glance. This overshooting is a natural response to the uncertainty and volatility created by the shock. The overshooting of exchange rates can have significant implications for international trade and investment. It can lead to increased uncertainty and risk, which may deter foreign investors from entering a market or encourage domestic investors to seek opportunities abroad. This can have a ripple effect on the overall economy, affecting everything from consumer spending to employment levels. Despite its short-term volatility, exchange rate overshooting is often seen as a necessary part of the adjustment process. It allows exchange rates to quickly realign with the new economic realities created by the shock, helping to restore market equilibrium. Over time, exchange rates tend to stabilize as the effects of the shock are absorbed and the economy returns to a more normal state.- Exchange rate overshooting is a natural and often necessary response to shocks in the economy. While it can create short-term volatility and uncertainty, it ultimately helps to restore market equilibrium and facilitate the adjustment process. By understanding this concept, policymakers and investors can better navigate the complexities of the global economy.
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