Answer to Question #279682 in Macroeconomics for Kaju

Question

why does exchange rate always overshoot its long run equilibrium following a monetary expansion? explain

Answer 1

An increase in money supply leads to increased sale of assets to foreigners and a devaluation of the nominal and real exchange rates leading to increased exports relative to imports and an outward shift of IS curve to match the outward shift of the LM curve. The impact of this is an increase in output and employment.

In the long run, the price level increases, reducing the real stock of money and shifting the LM curve back to its original position. The resulting excess demand for money causes the real exchange rate, output, and the IS curve to return to their full employment levels.

The price level will end up being higher and the nominal exchange rate lower in the same proportion as the original increase in the excess supply of money.