Q3. The overshooting model: Now consider a more realistic scenario where both prices and expected future exchange rates could change. Y is assumed to be fixed. Suppose that the Fed increases (decreases) money supply permanently (suppose initially the economy is in the long run equilibrium).

1. How does this change affect the equilibria in both the money market and foreign exchange market in the short run? Explain. Find the new short-run equilibria in both markets, using the graph you draw in Q1.
2. How does this change affect the equilibria in both the money market and foreign exchange market in the long run? Explain. Find the new long-run equilibria in both markets, using the graph you draw in Q1.
3. Does exchange rate overshooting happen in the short run? Explain why or why not.