Consider a two currency model where there are U.S. Dollars ($) and the Euro (€) being exchanged.
(a) Suppose a permanent decrease in the money supply causes the U.S. exchange rate ($/€) to change in the long run. Will the long run U.S. exchange rate be above or below the original equilibrium exchange rate? Please explain why we would have a new exchange rate.
(b) Will we observe exchange rate overshooting? Why? Please draw a graph to depict the time path of the U.S. exchange rate.
(c) Suppose the Federal Reserve announces the policy in part (a) one year in advance. How will your answers change? Will we observe exchange rate overshooting? Demonstrate your answer by showing the time path of the exchange rate ($/€).