Question

Describe the theoretical roots of and empirical implications of exchange rate overshooting. Describe carefully the properties of a model where it happens and the properties of a more complicated model where it does not? What empirical evidence is consistent with the idea?

Answer 1

Exchange rate overshooting is phenomena largely caused due to trade deficit or large trade surpluses or due to excessive dollar buying against any currency. Moreover interest rates play colloquial role here as wide deviation in interest rates and government yields and large scwke government spending and borrowing leads to overshooting exchange rate either on appreciation or depreciation side.

The economic implications here are widescale diminishing of forex reserves and higher inflation as major goods imported are pegged against US Dollar and also this creates stagflation kind of economy based on various empirical evidence.

The properties of this model states that exchanges rate shall have temporary effects to overreacting to modifications in the monetary policy to offset for sticky prices of goods in economic market which affects financial markets, derivatives market and bond markets as well as in more complicated model it shall also affect Commodity market to an extent.

For example the recent Coronavirus has caused Indian Rupee to overshoot to 76 per usd from 71 per usd. Subsequently gold prices pegged in dollar have increased dramatically in INR terms and so has stock markets plunged due to depreciation of INR and dollar selling which affects forex reserves and trade balance.

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