What is the overshooting phenomenon in exchange rate models, and what policy implications does it have?

• A. The exchange rate slowly adjusts to its long-run value
• B. The exchange rate initially undershoots its long-run value
• C. The exchange rate initially overshoots due to faster adjustment of asset prices
• D. The exchange rate remains unchanged after a shock

Answer: (C)

Overshooting happens when the exchange rate moves beyond its eventual long-run value right after a policy shock because asset prices adjust faster than goods prices. In a model with sticky prices, a policy change (like a money-supply or interest-rate shift) hits asset markets immediately, so the currency jumps to a level that reflects the new, lower (or higher) interest-rate environment. But goods prices and the overall price level don’t adjust as quickly. Because the higher price level will eventually come through, the fundamental, long-run depreciation is smaller than the initial move. As prices gradually adjust upward, the exchange rate tends to move back toward its long-run value.

The big takeaway is that policy can produce a large, short-run exchange-rate reaction that strengthens or weakens the currency beyond what the long-run fundamentals would suggest, and this channel can temporarily influence output and inflation. In practice, this means monetary policy can have pronounced short-run real effects via the exchange rate, but it also brings short-run volatility and uncertainty: the initial depreciation (or appreciation) may reverse over time as prices adjust, so policymakers must consider both the immediate impact and the eventual path.