I can understand that a pulmonary embolism (PE) causes an increase in dead space (an area of lung is no longer perfused but continues to be ventilated and cannot take part in gas exchange).  Increasing dead space alone should not cause hypoxia.

looking at it simplistically, a PE should not cause a shunt.  A shunt happens when an area of lung is perfused but not ventilated (for example in pneumonia).  A shunt causes hypoxia because deoxygenated blood bypasses gas exchange and returns to the left side of the heart.

I have read in a physiology book (West) that the hypoxia in a PE is due to a big increase in the blood flow through healthy parts of the lung, to the extent that gas exchange is limited by the fact that blood passes through the alveolus so quickly that oxygen does not have time to diffuse into the capillaries (diffusion limited).  If this is the case then why don't we all become hypoxic when we exercise?  OUr cardiac output increases dramatically and therefore blood flow through all parts of the lung must also increase dramatically (far more than can be explained by even a PE taking out an entire lung, which would only double blood flow to the healthy lung).

The only explanation that I can come to is that the areas of the lung directly affected by the PE, cause swelling in the adjacent alveoli (which remain perfused) and that the swelling/inflamation limits ventilation in those alveoli causing a shunt.

Does anybody have a better explanation?  I find it strange that hypoxia is one of the signs of a PE and yet there is no obvious explanation as to why it causes this.