Abstract

Exchange Rate Overshooting versus Efficient Foreign Exchange Markets

Dornbusch’s financial market theories offer guidance in the attempts made to explain the marked fluctuations of real exchange rates. The exchange rate overshooting reflected therein has, however, turned out to be irreconcilable with the empirically ascertained efficiency of foreign exchange markets. Against this background, the author shows that the condition at the base of the explanation given for overshooting in the Dornbusch model, i.e. the asymmetry in the formation/anticipation of price expectations in national and international financial markets, is not tenable. There is no reason explaining why the (same) market participants do not have identical expectations for the formation of interest rates on domestic capital markets and for the formation of exchange rates on foreign exchange markets, although the movements in money supply relevant to the domestic market need to be systematically recorded as well. In a generalized financial market theory approach, the author lifts this asymmetry and offers an explanation for the wide fluctuations of real exchange rates without getting into conflict with the efficiency of foreign exchange markets. However, this presupposes an interpretation, basically different in part, ofthe traditional conditions deciding on the money market equilibrium. Fluctuations of real exchange rates are the consequence of monetary distortions not anticipated in price expectations. The extent does, however, in no way correspond to the one assumed by Dornbusch in his model.