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

What will be an ideal response?

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 Ee is permanently higher after a permanent increase in the money supply. The expected exchange rate, Ee, has risen by the same percentage as Ms. 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.