Testing the Dornbusch Overshooting Theorem in Malawi

The overshooting theorem as pioneered by Rudiger Dornbusch has facilitated the creation of effective monetary policies in the past years. This paper re-examined the validity of the overshooting phenomenon based on the autoregressive distributed lag (ARDL) bound test approach. To achieve the main objective the paper firstly examined if the United States/Malawi Kwacha (USD-MWK) exchange rate overshoots or undershoots its long run exchange rate. In addition, the research paper has prior tested if there exist any significant fundamental macroeconomic fluctuations that may dictate spot exchange rate movements. In a theoretically derived price-flex model. The study has used a forty-one-year span of yearly nominal (USD-MWK) exchange rate data and that of monetary fundamentals data. Furthermore, empirically it has been found that only the inflation rate differential is economically significant in triggering spot rate rapid movements in the Price-Flex model. Conclusively, exchange rate overshooting has tested to be evident in Malawi. Solely attributed by the significant inflation rate differential where the other fundamentals are not statistically significant at 5% level of significance. This has been accounted to the constrained workability of the specified Price-Flex mathematical model in our economic environment. The study also discovered and concluded that inflationary pressures (irdif) emanating from the money market might be the key contribution of currency instability, fluctuations, and extreme exchange rate overshooting in Malawi. The limitation of this theoretical examination was that the overshooting theorem was tested on a single significant macroeconomic fundamental. The reason can be that the Price-Flex mathematical model has constrained full workability in our economic environment in explaining spot-exchange rate fluctuations.