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.