Recovering from the COVID-19 crisis, a small and open economy which practices a flexible exchange rate system has experienced a permanent positive aggregate demand shock due to a drastic increase in investment. Based on this situation and assuming the real wage is W/P, (a) draw the PC-MR, the IS-RX, and the AD-ERU diagrams to explain the path back

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Recovering from the COVID-19 crisis, a small and open economy which practices a flexible exchange rate system has experienced a permanent positive aggregate demand shock due to a drastic increase in investment. Based on this situation and assuming the real wage is W/P, (a) draw the PC-MR, the IS-RX, and the AD-ERU diagrams to explain the path back to medium-run equilibrium (MRE). [7 marks] (a) explain how this phenomenon has caused the overshooting of exchange rate. [3 marks]

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