Real Exchange Rate Overshooting in Large Depreciations: Determinants and Consequences

IMF Working Papers, May 22, 2020

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Canonical URL: Real Exchange Rate Overshooting in Large Depreciations: Determinants and Consequences

The consequences of large depreciations on economic activity depend on the relative strength of:
- the contractionary balance sheet effect, and
- the expansionary expenditure switching effect.
The two effects operate over different time horizons:
- the balance sheet effect hits almost immediately, and
- expenditure switching is delayed by nominal rigidities and other frictions.
The paper hypothesizes that the overshooting phase—observed early in the depreciation episode and driven by the balance sheet effect—is largely irrelevant for expenditure switching, which is more closely aligned with ex-post equilibrium depreciation.
Implication of hypothesis: larger real exchange rate overshooting should signal a relatively stronger balance sheet effect.

Overshooting is driven by factors associated with the balance sheet effect:
- high external debt,
- low reserves,
- low trade openness.
Overshooting-based measures of the balance sheet effect foreshadow post-depreciation output losses.
The balance sheet effect is strongest early on, while expenditure switching strengthens over the medium term.

Subject: Currency mismatches, Depreciation, Exchange rates, External debt, Financial sector policy and analysis, Financial statements, Foreign exchange, National accounts, Public financial management (PFM)
Keywords: balance sheet effect, Currency mismatches, debt intolerance, Depreciation, depreciation episode, equilibrium depreciation, Exchange Rate, Exchange rates, expenditure switching effect, External Debt, Financial statements, Global, Open Economy Growth, output loss, risk premium, short-term debt, WP