Consider our example of overshooting shown in Figure 19.6, in which the domestic money supply increased by 10 percent. Assume that the path of slow adjustment of prices is that the price level rises by about 2 percent per year for five years. What would the path of the nominal exchange rate be if PPP held for each year? Given the actual path for the exchange rate shown in Figure 19.6, does PPP hold in the short run? Does it hold in the long run?

Data From  Figure 19.6

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FIGURE 19.6 Exchange- Rate Path, Exchange-Rate Overshooting e, the exchange-rate value of foreign currency to: Domestic money supply unexpectedly rises 10% e 10% higher Original e Time