Overshooting and the exchange rate disconnect puzzle: a reappraisal

Transition to floating exchange rate regimes has led to sharp increases in nominal and real exchange rate volatilities with no corresponding changes in the distribution of fundamental macroeconomic variables. In the spirit of Dornbusch [1976], we assess whether nominal exchange rate overshooting is responsible for this phenomenon. As long as uncovered interest rate parity holds, nominal exchange rate overshooting is linked to a persistent fall in the spread between domestic and foreign nominal interest rates. We thus develop a limited participation model in an international setting. Introducting adjustment costs on money holdings in the limited participation framework substantially raises the magnitude of the overshooting dynamics. Overshooting indeed plays a key role in understanding the extreme nominal exchange rate volatility.