Exchange Rate Dynamics with Foreign Reserves: Revisiting the Dornbusch Overshooting Model

Abstract

The purpose of this study is to shed light on the management of foreign reserves that possibly have contradictory policy intentions and impacts, for instance, (1) to defend the domestic currency, (2) to depreciate the domestic currency. With this Möbius's strip‐like nature in mind, we extend the Dornbusch (1976) exchange rate overshooting model with the foreign reserves. Depending on financial vulnerability, the presence of foreign reserves could amplify or alleviate monetary policy shocks on the exchange rate.

Testing the absorber hypothesis of exchange rates for the overshooting of agricultural prices in China

“…The overshooting of agricultural prices is a common phenomenon, as shown in many previous studies (Lee 2016). According to the theory of money neutrality, the prices of all sectors in an economy will respond uniformly to a monetary expansion shock.…”

“…Subsequently, the overshooting hypothesis of exchange rates became a hot topic in macroeconomics and international economics research (Bordo 1980;Starleaf et al 1985;Devadoss and Meyers 1987;Choe and Koo 1993;Isaac 1998). As the overshooting of exchange rates is not the main focus of this study, we refer readers to Heinlein and Krolzig (2012) and Lee (2016) for detailed reviews.…”

“…They found that the effects differed by commodity due to the diverse supply--demand situation, production process, and storability. Further, Lee (2016) added to the model the parameter of external assets flowing into the country, ultimately optimising the overshooting model by emphasising the role of foreign exchange reserves. A larger domestic foreign exchange reserve means that the overshooting of exchange rates is significantly greater than that Dornbusch's (1976) setting.…”

Monetary policy and overshooting of agricultural prices in China: in a supply chain perspective

“…This is the so-called overshooting effect of agricultural prices, which has been widely demonstrated and become an important basis for explaining the price fluctuation of agricultural products (see, e.g. Saghaian et al ., 2002a, b; Asfaha and Jooste, 2007; Bakucs et al ., 2012; Lee, 2016; Alam and Gilibert, 2017).…”

“…Alam and Gilibert (2017) used the VAR model for analysis and found that the monetary policy, global economic situation, and US dollar index played an important role in the overshooting of agricultural prices. Further, Lee (2016) added to the model the parameter of external assets flowing into the country, ultimately optimizing the overshooting model by emphasizing the role of foreign exchange reserves. A larger domestic foreign exchange reserve means that the overshooting of exchange rates is significantly greater than that occurring in Dornbusch's (1976) setting.…”