Currency overshooting and the overvalued dollar

Currency overshooting was a key area for policy discussions and research concern in the 1970’s and 80’s by government officials and academics. The concern especially in the 1980’s was the significant overvaluation of the dollar in the mid-1980’s. These wide deviations from fair value were the main reasons for the Plaza and Louvre Accord for coordinated central bank intervention. It was believed that the deviations could not be solved without coordinated activity. The talk of overvaluation of the dollar and coordination is again evident.

The figure from Bank of America shows the size of deviations from fair value for the dollar relative to a basket of developed countries. There has been a significant change from overvaluation in 2000 to the current undervaluation. The Bank of America data does not show the dollar to be at all time extremes; however, it has levels which suggest that a revision is much more likely. Nevertheless, one of the problems with finding the fair value of any currency is that there is no consensus on what is fair value. Most banks will use multiple models to determine the deviation from fair value, so, at best, we can say there is a tendency for movement from equilibrium but we cannot say the amount of deviation with any precision.

We can see why there has been a recent strong dollar decline by using a classic overshooting model. The most widely used model of currency overshooting is based on the idea that exchange rates see more volatility as a response to some monetary shock because prices for good are relatively sticky. For markets to clear, there has to be an over-reaction in exchange rates. Some of the recent move down in the dollar is consistent with the Dornbusch sticky-price overshooting model. The Fed has increased money in response to the credit crisis. This monetary shock, it really was not expected before the credit problems of August, caused short-term rates to decline and led to a depreciation of the dollar. We can see that real rates have declined relative to the rest of the world and the dollar depreciation matched the change in real interest differentials. While these links are not perfect, the recent dollar decline should not be overly surprising.