This paper integrates a traditional Dornbusch overshooting model with a macro-economic model of hysteresis in foreign trade. We apply an approach which allows an aggregation of heterogeneous agents and which results in a continuous macroeconomic hysteresis-loop. In our model, short-run exchange rate overshooting generates a persistent current account effect, which feeds back into the exchange rate process and ultimately results in changes of the long-run equilibrium exchange rate. Monetary shocks can lead to hysteresis in both foreign trade and exchange rate processes, invalidating the long-run neutrality of money hypothesis and the purchasing power parity assumption of the conventional overshooting model.
