Explain the exchange rate over-shooting hypothesis

What will be an ideal response?

Many prices in the economy are written into long-term contracts and cannot be changed immediately when changes in the money supply occur. A permanent increase in M, holding P constant, increases the real money supply (M/P) and lowers the nominal interest rate (R). This shifts the dollar return schedule left. A permanent increase in M also creates the expectation that in the long run all prices including the exchange rate would rise. A rise in the expected exchange rate shifts the ERR(DM) schedule right. Therefore, in the short run equilibrium is established at point 2 In the long run the price level adjusts and rises proportionately with the money supply. Therefore, M/P and R return to their initial levels in the long run and the equilibrium exchange rate is determined at point 3. In other words, the exchange rate first overshoots and then returns to its long run level. Therefore, the fluctuations in E are much stronger than those of P.