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Explain the exchange rate over-shooting hypothesis

Explain the exchange rate over-shooting hypothesis

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An important feature of adustment process which happens due to monetary expansion is that exchange rate and prices do not move at the same time. When there is monetary expansion the interest rate decreases, so in this situation the exchange rate adust immediatly but only prices adjust gradually. Hence money expansion leads to an immediate change in the relative prices and competitivenes. This adjustment pattern involves exchange rate overshooting. This shows that short-run fluctuation in the exchange rate is more than its long-run fluctuation. In other words it can be said that in the short-run exchange rate overshoot. This can be shown in the below diagram.

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