show the phenomenon of overshooting.

Using the DD – AA framework, show the phenomenon of overshooting. Use a figure to explain when it is taking place.

Answer: The figure below shows the phenomenon of overshooting.    A permanent increase in the money supply starting from full employment equilibrium will shift the AA curve to the right from AA¹ to AA². Now, a steadily increasing price level shifts the AA and the DD schedules to the left until a new long-run equilibrium is reached. Note that point 3 is above point 1, because E^e is permanently higher after a permanent increase in the money supply.

The expected exchange rate, E^e , has risen by the same percentage as M^s. Notice that along the adjustment path between the initial short-run equilibrium (point 2) and the long-run equilibrium (point 3) the domestic currency actually appreciates (from E² to E³) following its initial sharp depreciation (from E¹ to E²). This exchange rate behavior is an example of overshooting, in which the exchange rate’s initial response to some change is greater than its long- run response.