5. Use the 3-equation open economy model to answer the following questions:

2 (a) Explain what the following statement means: "after a demand shock in a small open economy, the exchange rate often overshoots". Use an AD ERU diagram to help explain your answer. (4 points)

(b) What causes exchange rate overshooting? (2 points)

(c) What problems, if any, would you expect exchange rate overshooting to cause? (2 points)

(d) How could you modify the 3-equation open economy model so that exchange rate overshooting does not occur? Explain in words. (2 points)

e) Explain what is meant by this statement: "The behaviour of the nominal exchange rate in the model is a residual"