A re-examination of the exchange rate overshooting hypothesis: Evidence from Zambia

Abstract

Dornbusch’s exchange rate overshooting hypothesis has guided monetary policy conduct for many years, despite the fact that empirical evidence on its validity is mixed. This study re-examines the validity of the overshooting hypothesis by using the autoregressive distributed lag (ARDL) procedure. Specifi cally, the study investigates whether the overshooting hypothesis holds for the United States dollar/Zambian kwacha (USD-ZMK) exchange rate. In addition, the study tests whether there is a long-run equilibrium relationship between the USD-ZMK exchange rate and relevant macroeconomic fundamentals. Using monthly nominal USD/ZMK exchange rates and monetary fundamentals data from January 2000 to December 2012, the study fi nds no evidence of exchange rate overshooting. The results also show that there is no long-run equilibrium relationship between the exchange rate and the differentials of macroeconomic fundamentals. The implication is that macroeconomic fundamentals are insignifi cant in determining the exchange rate fl uctuations in the long run. This finding is inconsistent with the monetary model of exchange rate determination, which asserts that there is a long-run relationship between the exchange rate and macroeconomic fundamentals.

Key words: Exchange rates, monetary model, autoregressive distributed lag, cointegration, exchange rate overshooting