Consider an economy operating with a flexible exchange rate which is initially in) long-run equilibrium at point 1 in the diagram below, where:

Y= Y¹= Y^f; R= R¹= R*; and E = E^e = E¹

There is then a permanent DECREASE in the nominal money supply of the economy (M^S), with no change in any other exogenous variable.In the short-run the economy moves to a new SHORT-RUN equilibrium at point 2 in the diagram, where output equals Y² Y¹= Y^f and the exchange rate equals E² E¹.