Exchange Rate Dynamics: The Overshooting Model (With Sticky Prices)

The objective of this paper is to test the exchange rate dynamics by measuring the speed of adjustment of prices. In this overshooting model, we assume price stickiness (gradual adjustment). If the prices are adjusted instantaneously, we will have the monetarist view; otherwise, the overshooting one, due to slow adjustment of prices and consequently, it affects all the other variables and slowly the exchange rate. We outline, here, an approach of testing the dynamic models of exchange rate determination. This approach is based upon the idea that it is difficult to measure directly the process by which market participants revise their expectations about current and future money supplies. On the other hand, it is possible to make indirect inferences about these expectations through a time series analysis of related financial and real prices. Empirical tests of the above exchange rate dynamics are taking place for four different exchange rates ($/€, $/£, C$/$, and ¥/$). Theoretical discussion and empirical evidence have emphasized the impact of gradual adjustment and “overshooting” that it is taking place. Only for the $/€ exchange rate the monetarist model is correct.