Exchange rate overshooting can pose risks to economic agents by increasing short-term volatility. This blog post examines the causes and economic impact of exchange rate overshooting and the government’s policy responses to mitigate it.
The government implements policies by considering the characteristics of policy instruments to effectively achieve the goals of policy, which is a set of activities that affect people’s lives. Policy instruments have different characteristics in four aspects: coercion, directness, automaticity, and visibility. Coercion is the degree to which the government restricts the behavior of individuals or groups, and the regulation of the sale of harmful foods is highly coercive. Directness refers to the degree to which the government is directly involved in carrying out public activities and raising financial resources. If the government outsources the implementation of a policy to the private sector rather than implementing it directly, the policy is said to be less direct. Autonomy refers to the extent to which an existing organization is used to implement a policy without establishing a separate administrative body. The implementation of the electric vehicle subsidy program by the existing city hall environmental department is highly autonomous. Visibility is the degree to which the resources to implement a policy are explicitly identified during the budgeting process. In general, adjusting the degree of social regulation does not involve budget expenditures, so visibility is low.
As an example of the choice of policy instruments, let’s look at the economic phenomenon of exchange rates. Exchange rates, which refer to the exchange rate of a country’s currency against foreign currencies, tend to converge to a level that reflects a country’s underlying economic conditions, such as productivity and prices, in the long run. In the short run, however, exchange rates may deviate from this level. If the exchange rate moves in a different direction than expected, or even if it moves in the same direction as expected but the range of fluctuation is larger than expected, economic entities may be exposed to excessive risk. The phenomenon in which economic variables such as exchange rates and stock prices rise or fall excessively in the short term is called overshooting. Such overshooting is known to be triggered by price rigidity or fears caused by financial market volatility. Price rigidity here refers to the degree to which prices in the market are difficult to adjust.
To understand exchange rate overshooting due to price rigidity, let’s look at currencies as a type of financial asset and how exchange rates adjust in the long and short run in response to economic shocks. When an economic shock occurs, prices or exchange rates go through an adjustment process to absorb the shock. Prices are rigid in the short run because of long-term contracts and utility rate regulations, but they adjust flexibly in the long run. On the other hand, exchange rates can also adjust flexibly in the short run. This difference in the speed of adjustment of prices and exchange rates leads to overshooting. Exchange rates in the long run, where both prices and exchange rates are adjusted flexibly, are explained by the theory of purchasing power parity, which states that the long-run exchange rate is the ratio of one country’s price level to that of another country, and is considered the equilibrium exchange rate. For example, if the money supply in Korea increases and remains high, the domestic price level will also increase and the exchange rate will rise in the long run. In this case, the real money supply, which is the money supply divided by the price level, does not change.
However, in the short run, overshooting may occur due to rigid prices, which may lead to movements different from those based on purchasing power parity theory. For example, if the volume of money in Korea increases and remains at that level, the real money supply will increase due to rigid prices, and the market interest rate will fall. In a situation where capital flows freely between countries, a decline in market interest rates leads to a decline in the expected return on investment, which causes short-term foreign investment capital to flow out of the country or reduces the inflow of new foreign investment capital. In this process, the value of the domestic currency falls and the exchange rate rises. The effect of an increase in the volume of currency is the expected increase in the exchange rate in the case of flexible prices, plus the additional increase in the exchange rate caused by the outflow of funds due to the fall in interest rates. This additional increase is an overshoot of the exchange rate, and the larger and more persistent the overshoot, the greater the price rigidity. Over time, as prices rise, the real money supply returns to its original level, and funds that have flowed out of the country return to Korea as market interest rates recover, the exchange rate that has been overshooting in the short run converges to an exchange rate based on the theory of purchasing power parity in the long run.
The government mobilizes various policy tools to prevent and deal with problems such as short-term exchange rates becoming detached from economic fundamentals, causing excessive volatility, or long-term deviations from the equilibrium exchange rate level. Among the policy tools to mitigate exchange rate rigidity, which is the cause of overshooting, examples of low enforcement include prompt and accurate disclosure of relevant information to resolve the imbalance between foreign exchange supply and demand, and reduction of unnecessary price regulation. Meanwhile, to mitigate the negative effects of overshooting, the government tries to prevent a sharp contraction in domestic demand by adjusting taxes on imported essential goods whose prices have skyrocketed due to exchange rate fluctuations. It also provides exchange rate fluctuation insurance to import and export firms to guard against the damage caused by sudden exchange rate fluctuations, and provides payment guarantees for foreign currency borrowing. Such policies are very direct. In this way, the government tolerates exchange rate developments that reflect the underlying economic conditions, but uses proactive or reactive fine-tuning policy measures to promote the stability of the real economy and financial markets from the risks of short-term exchange rate fluctuations.
The selection and implementation of policy measures should not be limited to theoretical approaches, but should carefully consider their applicability and effectiveness in real situations. This is because the implementation of government policies has a direct impact on people’s lives. For example, government intervention to stabilize the exchange rate can have a significant impact on importing and exporting firms. While export companies can expect more profits due to the increase in the exchange rate, import companies may suffer from increased costs. Therefore, it is important for the government to coordinate the interests of different economic entities and develop a balanced policy.
The government’s ability to implement policies and the public’s trust in the government are also important variables. The success of a policy depends not only on the nature of the policy measures, but also on the ability of the government agencies that implement them and the cooperation of the public. The government must strive to implement policies in a transparent and fair manner to maximize their effectiveness. This is an important factor in increasing public confidence and acceptance of policies.
Finally, cooperation with the international community cannot be ignored. In the era of the global economy, economic indicators such as exchange rates are often difficult to control with a single country’s economic policies. Therefore, cooperation and coordination with the international community is necessary, which is also important for international economic stability and growth. For example, major economic powers can cooperate to coordinate exchange rate policies to minimize global economic instability.
The government should consider these various factors in selecting and implementing policies. This is an essential process for improving people’s living standards and promoting sustainable economic growth. The role of the government is not simply to regulate and control, but to formulate and effectively implement comprehensive policies for the welfare and economic stability of the people. Through this process, the government will be able to win the trust of the people and create a better society.
