In our discussion of short-run exchange rate overshooting, we assumed real output was fixed. Assume instead that an increase in the money supply raises real output in the short run.

a) How does this affect the extent to which the exchange rate overshoots in the short run?

b) Is it possible that the exchange rate undershoots (relative to its long-run value) in the short run? Explain how this can happen.

c) Explain with the help of a figure, the transition to long-run equilibrium if the exchange rate overshoots relative to its long-run value.

d) Explain with the help of a figure, the transition to long-run equilibrium if the exchange rate undershoots relative to its long-run value.

Note 1: Undershooting is when the spot exchange rate in the short run Er is less than the exchange rate in the long-run Elr. Note 2: Answer parts a, b, c, and d assuming an increase in money supply.