The Effect of Excessively-Elastic Expectations on Exchange Rate Volatility in the Dornbusch Overshooting Model

Bilson has described the empirical finding that the forward exchange rate overestimates the speed of return to equilibrium as a finding of ‘excessive speculation’, and has drawn implications for the volatility of the exchange rate. The present paper pursues this tack within the sticky-price monetary model made famous by Dornbusch. It is shown theoretically that if the market overestimates the speed of adjustment, the degree of overshooting is reduced. In this sense ‘excessive speculation’ leads to reduced volatility.