What is meant by exchange rate overshooting? Why does it occur?

What is meant by exchange rate overshooting? Why does it occur?

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January 6, 2021
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What is meant by exchange rate overshooting? Why does it occur?

 

Answer and ExplanationSolution by a verified expert

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Exchange rate measures the value of one in terms of another currency.

Explanation

When a response to a change in market fundamentals is greater in the short run than the long run response it is referred to as exchange rate overshooting. It is an important phenomenon as it helps in explaining why exchange rates change so sharply from day to day.
 
Prices in the goods market take some time to adjust whereas prices in the money market adjust instantaneously. Such differences in the adjustment speed of different markets lead to the occurrence of exchange rate overshooting.

Verified Answer

Exchange rate is said to overshoot when it's response to a change in market fundamentals is greater in the short run than its long run response.
 
Overshooting occurs due to the difference of speed of adjustment across different markets.

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