Exchange rate volatility: Intraregime Volatility: Dornbusch Overshooting Model
Perhaps one of the best-known explanations for intraregime volatility is the seminal overshooting model of the economist Dornbusch (1976). Thismodel is also in themonetary class, but assumes that consumer prices are sticky in the short run (although flexible in the long run) while asset prices and yields (the exchange rate and interest rates) are continuously flexible. In the short run, income is assumed to be fixed. In this context, an increase in the domestic money supply upsets money market equilibrium and leads to a proportional depreciation of the long-run, or equilibrium, price level and exchange rate (which are flexible). In the short run, however, or in the immediate aftermath of the money supply increase, equilibrium can be restored only by a change in the interest rate (since the price level and income are held constant by assumption). But in a world of high, or complete, capitalmobility the domestic interest rate is tied into the foreign rate through the uncovered interest rate parity condition and can change only if the expected change in the exchange rate is assumed to be nonzero.
The expected change in the exchange rate is, however, nonzero in the overshootingmodel because it is governed by a regressive expectations mechanism: a current depreciation of the exchange rate relative to its equilibrium, or long-run, value is expected to be reversed in the future. In other words, a current depreciation of the exchange rate produces the expectation of a future appreciation. So, in response to the increase in the money supply, what is required is the current exchange rate to move more than proportionally to the long-run, or equilibrium, exchange rate value (which moves in proportion to the increase in the money supply) to allow the domestic interest rate to fall below the world level: the exchange rate overshoots its long-run value and, by implication, the current change in themoney supply. As in the magnification story, the current exchange rate is more volatile than current fundamentals. The extent of the overshooting is governed by how sensitive interest rates are tomoney supply changes (the less sensitive, the more the exchange rate will move) and the sensitivity of the expected change in the exchange rate with respect to the gap between the current and equilibrium exchange rates.