Financial Panic and Exchange Rate Overshooting during Currency Crises

During currency crises, some currencies depreciate more than the post-crisis exchange rate level, which can be described as exchange rate overshooting. Previous studies have claimed that a tight monetary policy, represented by an increase in the interest rate, stabilizes an exchange rate by causing currency appreciation, thereby explaining overshooting. This paper tests the hypothesis that overshooting simply reflects the overreaction of investors due to financial panic during currency crises, regardless of subsequent domestic policies. Empirical results suggest that: (1) the positive relationship between monetary tightening and the overshooting measure is very sensitive to sample selection; and (2) the measure of financial panic has a significant and positive relationship with the measure of overshooting in non-European countries.Currency crisis, financial panic, exchange rate overshooting,