Overshooting model

The overshooting model or the exchange rate overshooting hypothesis, first developed by economist Rudi Dornbusch, is a theoretical explanation for high levels of exchange rate volatility. The key features of the model include the assumptions that goods' prices are sticky, or slow to change, in the short run, while the prices of currencies are flexible, that arbitrage in asset markets holds, via the uncovered interest parity equation, and that expectations of exchange rate changes are "consistent" — that is, rational. The most important insight of the model is that adjustment lags in some parts of the economy can induce compensating volatility in others; specifically, when an exogenous variable changes, the short-run effect on the exchange rate can be greater than the long-run effect, so that in the short run the exchange rate overshoots its new equilibrium long-run value.