The Overshooting Model of Exchange Rate Determination

This work aims to examine and test another model of exchange determination, the exchange rate
overshooting model by examining its dynamics and measuring the speed of adjustment of prices.
Then, in this overshooting model it is assumed that prices are sticky; thus, there is gradual adjustment
of prices after a monetary shock. If the prices are adjusted instantaneously, it will fall to the monetarist
view; otherwise, to the overshooting one, due to slow adjustment of prices and consequently, a
monetary shock affects all the other variables and slowly the exchange rate. On the one hand, this
study outlines, here, an approach of testing the dynamic models of exchange rate determination. This
approach is based upon the idea that it is difficult to measure directly the process by which market
participants revise their expectations about current and future money supplies. On the other hand, it is
possible to make indirect inferences about these expectations through a time series analysis of
related financial and real prices. Empirical tests of the above exchange rate dynamics are taking place
for four different exchange rates ($/€, $/£, C$/$, and ¥/$). Theoretical discussion and empirical
evidence have emphasised the impact of gradual adjustment and “overshooting” that it is taking place.
Only for the $/€ exchange rate, the monetarist model is correct. This is an indication that there is price
control (price inertia) in countries that have less market oriented economies.