What is exchange rate overshooting in simple terms?

After a monetary shock, goods prices change slowly but the exchange rate reacts at once, so it first moves further than its final level and then gradually comes back.

Why does overshooting happen?

With sticky prices, interest rates fall in the short run, and interest parity then requires an expected future appreciation, so today's exchange rate must depreciate beyond its long-run level.

Exchange Rate Overshooting

📈 Economics By CampusDown Wiki Editorial Team Last updated October 26, 2026

Exchange rate overshooting is an international macroeconomic model explaining that because goods prices adjust slowly while financial markets react at once, a monetary shock such as a rise in the money supply causes the currency to depreciate temporarily by more than its new long-run equilibrium level before gradually returning to it. Rudiger Dornbusch proposed it in 1976.

Contents

1. Background and model structure
2. The overshooting mechanism
3. Empirical debate and later developments
4. FAQ
5. References

Background and model structure

After the Bretton Woods system collapsed in 1973 and major currencies began to float, exchange rates swung far more than fundamentals such as prices or the current account. Rudiger Dornbusch (1976) offered a model that explained this volatility without assuming irrational markets. It combines the capital mobility of the Mundell–Fleming model (Mundell, 1963; Fleming, 1962) with rational expectations and rests on three elements: purchasing power parity holds in the long run, uncovered interest parity holds continuously in financial markets, and goods prices are sticky in the short run.

The overshooting mechanism

Suppose the central bank permanently increases the money supply. In the long run, prices rise in proportion and the currency depreciates by the same percentage. In the short run, however, prices do not move at once, so real money balances rise and domestic interest rates fall to clear the money market. For investors to keep holding domestic assets despite the lower interest rate, they must expect the home currency to appreciate in the future. That requires the current exchange rate to have depreciated by more than its long-run level, so it overshoots right after the shock and then appreciates gradually toward equilibrium as prices rise. Frankel (1979) extended the model with inflation expectations, explaining exchange rates through real interest differentials.

Empirical debate and later developments

Meese and Rogoff (1983) caused a stir by showing that structural exchange rate models of the 1970s, including Dornbusch's, forecast no better out of sample than a simple random walk, and Rossi (2013) later reviewed the research on exchange rate predictability. Eichenbaum and Evans (1995) documented a delayed overshooting puzzle, finding that after U.S. monetary tightening the dollar kept appreciating for one to three years rather than jumping at once. Faust and Rogers (2003) and Scholl and Uhlig (2008), by contrast, found that results depend on the identification method, and Bjørnland (2009) found immediate overshooting consistent with Dornbusch in data for small open economies. Obstfeld and Rogoff (1995) carried the sticky-price logic into new open economy macroeconomics with microfoundations, and Rogoff (2002) judged that a quarter century on the model remained the starting point of international macroeconomics. Engel (2014) reviewed the problem that uncovered interest parity fits the data poorly.

FAQ

What is exchange rate overshooting in simple terms?: After a monetary shock, goods prices change slowly but the exchange rate reacts at once, so it first moves further than its final level and then gradually comes back.
Why does overshooting happen?: With sticky prices, interest rates fall in the short run, and interest parity then requires an expected future appreciation, so today's exchange rate must depreciate beyond its long-run level.

Sources reviewed: 2026-10-26

References

Dornbusch, R. (1976). Expectations and exchange rate dynamics. Journal of Political Economy, 84(6), 1161–1176.
Mundell, R. A. (1963). Capital mobility and stabilization policy under fixed and flexible exchange rates. Canadian Journal of Economics and Political Science, 29(4), 475–485.
Fleming, J. M. (1962). Domestic financial policies under fixed and under floating exchange rates. IMF Staff Papers, 9(3), 369–380.
Frankel, J. A. (1979). On the mark: A theory of floating exchange rates based on real interest differentials. American Economic Review, 69(4), 610–622.
Meese, R. A., & Rogoff, K. (1983). Empirical exchange rate models of the seventies: Do they fit out of sample? Journal of International Economics, 14(1–2), 3–24.
Eichenbaum, M., & Evans, C. L. (1995). Some empirical evidence on the effects of shocks to monetary policy on exchange rates. Quarterly Journal of Economics, 110(4), 975–1009.
Obstfeld, M., & Rogoff, K. (1995). Exchange rate dynamics redux. Journal of Political Economy, 103(3), 624–660.
Rogoff, K. (2002). Dornbusch's overshooting model after twenty-five years. IMF Staff Papers, 49(Special Issue), 1–34.
Faust, J., & Rogers, J. H. (2003). Monetary policy's role in exchange rate behavior. Journal of Monetary Economics, 50(7), 1403–1424.
Scholl, A., & Uhlig, H. (2008). New evidence on the puzzles: Results from agnostic identification on monetary policy and exchange rates. Journal of International Economics, 76(1), 1–13.
Bjørnland, H. C. (2009). Monetary policy and exchange rate overshooting: Dornbusch was right after all. Journal of International Economics, 79(1), 64–77.
Engel, C. (2014). Exchange rates and interest parity. In G. Gopinath, E. Helpman & K. Rogoff (Eds.), Handbook of International Economics, Vol. 4 (pp. 453–522). Amsterdam: Elsevier.
Rossi, B. (2013). Exchange rate predictability. Journal of Economic Literature, 51(4), 1063–1119.

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This article was last updated on October 26, 2026. It is based on widely recognized original works and textbooks; when citing it in a paper, please check the original sources listed in the references.