Question

Assume instead that an increase in the money supply raises real output in the short run. Explain with the help of a figure, the transition to long run equilibrium if the exchange rate undershoots relative to its long run value.

Answer 1

Increase in money supply reduces the interest rates which increases investment spending.in short run the economy moves to a new short run equilibrium,with both the aggregate price level and aggregate output increasing in short run nominal wages will rise over time,causing SARS curve to shift left word this process stop when the economy end up at a point of both short run and long run equibilirium.In short run ,the economy moves to a new short run macroeconomic equiliblirium at a level of real gdp below potential output and a lower aggregate price level both the aggregate price level and aggregate output decrease in short run.an increase in the money supply increase in the quantity of goods and services demanded shifting ad to the right.expansionary monetary policy refers to any policy initiative by a countrys central bank raise its money supply.expansionary monetaey policy can mean increase in the rate of growth of the money supply rather than of mere increase in money.this section first brings in a simplified version of the overshooting model.remarks are than made on the controversies cost by the overshooting model,which offers national explanations to those disapproving results in the above reviewed empirical literature.follwig a change in money supply moves towards a new short run exchange rate target in the short run and converge to anew long run equilibrium exchange rate in the long run.in the long run the exchange rate is expected to appreciate in response to acontractionary monetory policy stock.this ensure that purchasing power parity is retored because the shock induces a permanent decline of the domestic price level.in the short run as domestic interest rates exceed foreign rates,markets participants expect the exchange rate to depreciate.the term overshooting indicates the excessive fluctuation of the nominal exchange rate in responce to a change in the monetory supply.this phenomenon,first defined by dornbusch abd due to price stickness,contributes to explaning the high volatility displayed by nominal exchange rate.in the medium run,prices adjust according to the money supply and the exchange rate moves downward .hence,in the long run,the principle of neutrality is satisfied.the purpose of this paper is to calculate purchasing power parity rates and the real exchange rate using several methods of calculation to estimate long run equiblibrium real exchange rate in transition economies,mainly in esatern european countries considered in transition,such as poland.lets consider for example,a rise(decrease)in money supply...thus the exchange rate adjusts instantaneously to equate supply with demand for foreign exchange,overshooting(undershooting)its long run equilibrium level.the intuitive explanation for undershooting is that monetary expansion caues the long run equilibrium price level to rise,and this in turn may lead to the expectation that the domestic interest rate will rise.money market equilibrium m-p+=i+y.undershoot relative to its long term value.