1. Short-run and Long-run equilibrium analysis using the PPP model. The effects of a decrease in the domestic money supply.

Suppose the Canadian economy was initially in a long-run equilibrium.

Suppose that the Central Bank of Canada decided suddenly to implement a one-time decrease in money supply.

(f) Explain what we mean by exchange rate over-shooting. Why do the exchange rate tend to overshoot? Use figures with time on the horizontal axis to depict exchange rate over-shooting following a decrease in the domestic money supply (Hint: Over-shooting can be both upwards or downwards.)