Exchange rate dynamics: Where is the saddle path?

Undeniably, exchange rate behavior is one of the most intensely studied topics in the international finance literature. The overshooting model a la Dornbusch provides a prominent explanation for high variability of (real) exchange rates. Since its publication in the 1970s (Dornbusch, 1976), the over-shooting model occupies a key position in modeling exchange rate dynamics (Frankel and Rose, 1995). A notable feature of the model is the saddle-path dynamics, which follows from the assumption that the price of goods and the exchange rate have different adjustment speeds. Under the sticky price assumption, the exchange rate overshoots its new equilibrium level in response to shocks so that the system reaches a new saddle-path trajectory and converges to the new equilibrium position. Strictly speaking, ‘overshooting dynamics’ is the consequence of the presence of ‘saddle-path dynamics’.1 In the literature, nonetheless, ‘overshooting’ is commonly used to describe this class of exchange rate models. Thus, for convenience, in the following sections the terms ‘overshooting dynamics’ and ‘saddle-path dynamics’ are used interchangeably. © 2024 Informa UK Limited