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

Answer: The figure below illustrates the phenomenon of overshooting. A permanent raise in the money supply starting from full employment equilibrium will shift the AA curve to the right from AA¹ to AA². Now a progressively rising 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 for the reason that Ee is permanently higher after a permanent increase in the money supply. The predictable exchange rate Ee has raised by the same percentage as Ms. Notice that beside the adjustment path between the initial short-run equilibrium (point 2) and the long-run equilibrium (point 3) the domestic currency essentially appreciates (from E² to E³) following its initial sharp depreciation (from E¹ to E²). This exchange rate deeds is an example of Overshooting in which the exchange rate's initial response to some change is greater than its long-run response.