next we have the monetary policy change and overshooting the effect of a change in monetary policy on

the exchange rates is different under this model the bending upon whether we are considering short run
or long run analysis .
Don Bush says that due to the monetary policy change exchange rates in the short run will overshoot
their long-run values.
we provide a brief analysis of the effects of monetary policy change in the long run we will then discuss
how exchange rates overshoot in the short run through the analysis.

we assume that there is an unanticipated permanent increase in money supply the analysis for a
reduction in money supply can be understood in a similar manner in the long run output is at its
fullemployment level and prices are flexible. An increase in money supply leads to an increase in
aggregate demand .since output is fixed at its maximum potential it will cause an equal proportion 'el
increase in the price level making the real money supply same as before .the exchange rate or e will
increase making real exchange rates same thus there will be no effect on the real variables real money
supply, real exchange rates ,output and real income and the domestic interest rates .

in the short run prices are sluggish to adjust. if there is a unanticipated permanent increase in money
supply exchange will become highly volatile and will depreciate by a huge amount . an unexpected
permanent increase in nominal supply of money with prices being sticky in the short run implies an
increase in the real money supply in the short run . this would cause a decrease in the rate of interest to
restore the equilibrium in the money market in the short run and as a result the domestic rate of
interest will fall below and world rate of interest. consequently the return on domestic assets will
become less than that on foreign assets .in the market for assets this will be a state of disequilibrium in
the short run .

how will equilibrium be restored especially in the long run.

in the long run the level of output and demand for it must be at the full employment level of output the
rate of interest to must come back to its original level . the only change the domestic economy will be
that the price level would have increased by the same proportion as the permanent increase in the
nominal money supply . with the price level increasing in the same proportion as the nominal money
supply ,the level of aggregate demand would be at the full employment level if and only if the nominal
exchange rate II were to increase by the same proportion as the price level. given that the rate of
interest is at its original level. with the rate of interest returning to its original level which is the same as
the world rate of interest there would be a restoration of long-run equilibrium in all markets if the
nominal rate of exchange II were to indeed increase by the same proportion by the price level .this is
known to the economic agents hence once it has been realized that the nominal money supply has been
increased by a certain given level they would be able to calculate correctly the proportional increase in
nominal rate of exchange .however the nominal rate of exchange does not increase directly to that level
in the short-run but increases by a greater amount. this is because in the short-run the price level does
not increase and therefore the real money supply and the domestic rate of interest remain above and
below their long-run levels respectively. under these circumstances international capital movements
would be in equilibrium only if the rate of return on domestic assets were to be the same as the return
on foreign assets . however the domestic rate of interest and hence and hence the return on domestic
assets is lesser than the world rate of return which is equal to the world rate of interest. the only way in
which the rate of return on domestic assets can equal the world rate of interest in the short-run is for
there to be an expected appreciation to an extent equal to the difference between the world rate of
interest and the domestic rate of interest . the nominal rate of exchange can only fall to its expected and
higher level only if in the short-run it rises to a greater extent than its long-run equilibrium
level .remember that the rate of exchange had just much more rapidly than the price level . hence the
rate of exchange increases - it's a much higher level even though and indeed because the price level has
not increased .

this is what constitutes the phenomenon of overshooting this is a heuristic explanation which dawn
Bush explained by means of a rigorous model figure explains the effect of an increase in money supply in
short run through the phase plane diagram in the figure price is shown on the x-axis and exchange rate
is shown on the y-axis the economy is at equilibrium at Point Capital V naught where P dot is equals to 0
and e dot is equals to 0 lines intersect s1 s1 is the salary path now suppose there is an increase in money
supply money supply appears as a shift variable in a dot is equals to 0 line with an increase in money
supply exchange rate will depreciate thus a dot is equals to zero line shift it shifts from a dot naught is
equal to 0 to e dot 1 is equals to zero as a result the solution of the system of equations E and s will
change leading to a new saddle path of test to s2 the new equilibrium should have been at Point E 1
however prices are slow to exist with the change in money supply but exchange rates are not the
economy does not move to point P 1 immediately does initially economies will move to point e 2 where
Yi dot 1 is equals to zero line and s2 s2 intersect because exchange rates are flexible at Point E 2 they
have fully adjusted basically the exchange rates have depreciated by a large amount then it should have
been if the prices were not sluggish the sluggishness of prices has been counter balanced by over
movement in exchange rate this over movement is worth Don Bush calls overshooting of in trades the
new equilibrium exchange rates should be e1 but it overshoots this value and settle down at E 2 it is
when the price level start adjusting that the economy will reach its new equilibrium long-run at Point E
1 thus in the short-run an increase in money supply moves the economy from point P naught to e 2 in
the long run due to adjustments of price level the economy will move from e 2 to e 1 to visualize the
time path of different variables we have the figures shown at time T naught money supply increases
from M naught to M 1 in the long run there is an equal increase in the exchange rates and the price level
however in the short run at time T naught exchange rates jump to e 2 since prices are slow to adjust
they increase at a slower pace to their long-run value of P 1 as a result exchange rates get back to their
long-run level of e 1 when prices also get fully adjusted if initially output was at its full employment level
an increase in money supply will increase output beyond its full employment level it is when prices start
adjusting output will return back to its long-run level as shown in the figure the module can be
summarized in the following points
 Daanish exchange rates overshooting model shows why the exchange rates are volatile in short-run
even if there are flexible exchange rates and agents have rational expectations the model combines the
Keynesian short-run framework with the monetarist long-run analysis to link the theory with the real
world the major assumptions of the model are sticky prices perfect capital mobility flexible exchange
rates and perfect foresight of the agents mathematically 6 equations dip the structure of this model for
e the structure of this model for equations represents the equilibrium of capital market money market
and goods market and the Phillips curve respectively the two equations that is P is equals to 0 and E is
equals to 0 shows the dynamic that leads the economy to the equilibrium and increase in the money
supply in the short-run depreciates the domestic currency well above its long-run level causing
overshooting in the long run and increase in money supply has no effect on the real variables only
nominal variables changes you