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How would the Overshooting Model be affected by a change in foreign interest rates?  

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mrb31 | Student, Undergraduate | (Level 1) eNoter

Posted December 9, 2011 at 7:49 AM via web

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How would the Overshooting Model be affected by a change in foreign interest rates?

 

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belarafon | High School Teacher | (Level 2) Educator Emeritus

Posted December 13, 2011 at 11:52 AM (Answer #1)

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The Overshooting Model is a theory proposed by Rudi Dornbusch, who claimed that the "sticky" nature of money and goods prevented markets from adapting immediately to changes in the value and supply of money. According to this theory, when the value or supply of money changes, the market will overadjust the commodity prices while the goods themselves will remain at the old pricing. Eventually, the goods will adjust their pricing as well to reach a new equilibrium.

In this model, the Foreign Interest Rates would have an effect on their own markets first, and then on other markets. Any markets affected by the specific Foreign Interest Rates that changed would overreact, swinging up or down, and the price of goods would remain the same until the market corrected for the new pricing of commodities. The greater the change, the larger the adjustment; when the adjustment stops, the prices of goods shifts to match the new price of commodities and the market settles.

For example, if the Euro drops in value, any European products sold and consumed in the United States would first remain at their old price, but stock prices would drop as the market decided that these products are of lesser value. The change in price would eventually affect the goods, but not until the price has swung further than would normally be predicted based on the sale numbers. When the goods themselves drop in price, since they cost "less" to manufacture, the market's original adjustment becomes the new norm.

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