This blog post examines the causes and economic impacts of exchange rate overshooting, along with the government’s policy responses to mitigate it.
The government implements policies by considering the characteristics of policy instruments to effectively achieve policy objectives, which encompass all activities affecting citizens’ lives. Policy instruments possess diverse characteristics across four dimensions: coerciveness, directness, automaticity, and visibility. Coerciveness refers to the degree to which the government restricts the actions of individuals or groups; regulations on the sale of harmful foods exhibit high coerciveness. Directness signifies the extent to which the government directly engages in performing public activities and securing resources. When the government delegates policy implementation to the private sector rather than executing it directly, directness is low. Autonomy refers to the degree to which existing organizations are utilized for policy implementation without establishing separate administrative bodies. Implementing an electric vehicle subsidy program through an existing city hall environmental department exhibits high autonomy. Visibility indicates the degree to which funding for policy implementation is explicitly revealed during the budget formulation process. Generally, adjusting the level of social regulation does not involve budget expenditures, resulting in low visibility.
Let us examine an example of policy instrument selection related to exchange rate phenomena. The exchange rate, which represents the exchange ratio of a domestic currency against foreign currencies, converges in the long term to a level reflecting a country’s fundamental economic conditions, such as productivity and prices. However, in the short term, the exchange rate may deviate from this level. If the exchange rate moves in an unexpected direction, or even if it moves in the expected direction but with a larger-than-anticipated fluctuation, economic agents may be exposed to excessive risk. The phenomenon where economic variables like exchange rates or stock prices rise or fall excessively in the short term is called overshooting. Such overshooting is known to be triggered by price rigidity or anxiety stemming from financial market volatility. Here, price rigidity refers to the degree to which prices are difficult to adjust in the market.
To understand exchange rate overshooting due to price rigidity, consider currency as a type of financial asset and examine how exchange rates adjust to economic shocks in the short and long term. When an economic shock occurs, prices and exchange rates undergo an adjustment process to absorb the shock. Prices are rigid in the short term due to factors like long-term contracts and regulated public utility rates, but they adjust flexibly in the long term. Conversely, exchange rates can adjust flexibly even in the short term. This difference in adjustment speed between prices and exchange rates causes overshooting. In the long run, when both prices and exchange rates adjust flexibly, the exchange rate is explained by the purchasing power parity theory. According to this theory, the long-term exchange rate is the ratio of the domestic price level to the foreign price level, and this is considered the equilibrium exchange rate. For example, if the domestic money supply increases and remains elevated, domestic prices will also rise in the long run, causing the long-term exchange rate to appreciate. At this point, the real money supply (money supply divided by prices) remains unchanged.
However, in the short run, price rigidity can cause movements diverging from the exchange rate implied by the purchasing power parity theory, potentially leading to overshooting. For instance, if the domestic money supply increases and remains elevated, prices are rigid, so the real money supply increases, causing market interest rates to fall. In an environment of free capital mobility between countries, falling market interest rates lead to a decline in the expected rate of return on investment. This results in short-term foreign investment capital flowing out of the country or a reduction in the inflow of new foreign investment capital. During this process, the value of the domestic currency falls, and the exchange rate rises. The effect of increased money supply manifests as the expected exchange rate appreciation due to flexible prices, compounded by additional appreciation triggered by capital outflows caused by falling interest rates. This additional appreciation is the exchange rate’s overshoot. The magnitude and persistence of this overshoot increase with greater price rigidity. Over time, as prices rise, the real money supply returns to its original level. Funds that had flowed overseas return domestically due to a rebound in market interest rates. Consequently, an exchange rate that had risen excessively in the short term converges in the long run to a rate based on the purchasing power parity theory.
To prevent and address situations where the short-term exchange rate deviates excessively from underlying economic fundamentals—such as experiencing sharp, abnormal fluctuations or remaining persistently detached from the equilibrium exchange rate level—the government employs various policy tools. Among policy tools to alleviate price rigidity, a cause of overshooting, less coercive examples include promptly and accurately disclosing relevant information to resolve foreign exchange supply-demand imbalances or reducing unnecessary price regulations. Meanwhile, to mitigate the negative spillover effects of overshooting, the government may also seek to prevent a sharp contraction in domestic demand by adjusting taxes on essential imported items whose prices have surged due to exchange rate fluctuations. Furthermore, to prepare for damage caused by sharp exchange rate fluctuations, it may provide exchange rate fluctuation insurance to import and export companies or offer payment guarantees for foreign currency borrowing. These policy tools are characterized by a high degree of directness. Thus, the government tolerates exchange rate trends reflecting fundamental economic conditions while implementing policies to stabilize the real economy and financial markets from risks posed by short-term sharp fluctuations. This is achieved through preemptive or ex-post fine-tuning policy tools.
The selection and implementation of policy tools must go beyond mere theoretical approaches, requiring careful consideration of their applicability and effectiveness in real-world situations. This is because government policy execution directly impacts citizens’ livelihoods. For example, government intervention to stabilize exchange rates can significantly affect import and export companies. Exporters may anticipate higher profits due to a rising exchange rate, while importers may face difficulties from increased costs. Therefore, it is crucial for the government to balance the interests of various economic actors and formulate balanced policies.
Furthermore, the government’s policy implementation capacity and public trust are also critical variables. The success of a policy depends not only on the characteristics of the policy instrument itself but also on the capabilities of the government agencies executing it and the cooperation of the public. To maximize policy effectiveness, the government must strive for transparent and fair policy implementation. This is a key factor in enhancing public trust and increasing policy acceptance.
Finally, cooperation with the international community is also an element that cannot be ignored. In the era of the global economy, economic indicators such as exchange rates are often difficult to regulate solely through a single country’s economic policies. Therefore, cooperation and coordination with the international community are necessary, and this is also important for international economic stability and growth. For example, major economic powers can minimize instability in the global economy by cooperating to coordinate exchange rate policies.
The government must comprehensively consider these diverse factors when selecting and implementing policy measures. This is an essential process for improving citizens’ living standards and promoting sustainable economic growth. The government’s role extends beyond mere regulation and control; it involves formulating comprehensive policies for citizens’ welfare and economic stability and executing them effectively. Through this process, the government can earn public trust and build a better society.
