What is the Dornbusch overshooting model?
The overshooting model describes how exchange rates can react disproportionately to monetary shocks. When a central bank unexpectedly tightens monetary policy, for instance, interest rates rise. In the short run, capital flows in, appreciating the currency. But because prices adjust more slowly than asset markets, the currency initially moves further than it eventually will, 'overshooting' its long-run equilibrium level before gradually depreciating back. This highlights the crucial role of expectations and price stickiness.
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