Question

2. As we have seen in past crises, sometimes exchange rate of a country gets devalued by more than one would predict based on parity condition, such as the interest rate parity (overshooting of exchange rates). Why is overshooting even more when countries have a lot of foreign debt?

Answer 1

Overshooting of depreciation or devaluation of exchange rate is result of stickiness of prices of goods, so that prices of asset such as currency has to adjust by more as compared when prices of goods are more flexible

now when depreciation/devaualtion takes place and country has high foreign debt, the country can become bankrupt. This is because value in domestic currence of foreign currency denominated debt increases post depreciation and there is possibility that in terms of local currency, there will be less liquid asset as compared to value of debt.If this happens the value of domestic currency depreciates further, since now investor will try to leave that currency and will dump it which further decreases its value