Question

First Question : In a monetary model with floating exchange rates, what will happen to exchange rate, if the Central Bank of Turkey has decided to increase money supply? Discuss.

Second Question : In a monetary model with fixed exchange rates, discuss short run and long run effect of a devaluation on balance of payments.

Answer 1

As Central Bank of Turkey increases the money supply in the economy, this would lead to a decrease in the interest rates. The primary reason for the decrease in the interest rate is that now there is excess money supply in the economy and in order to induce people to hold more money, the interest rate is reduced and the money market is at equilibrium.

The decline in the interest rates means that the return on investment in Turkey is low as compared to the other countries and thus the demand for Turkish Lira declines. This further leads to the depreciation of Turkish Lira with respect to the other currencies in the foreign exchange market.
This also makes the Turkish goods cheaper in the global market and demand for these goods increases by the foreigners increases which ultimately leads to the aggregate demand in Turkey and thus the production of goods also increases in Turkey and there is a rise in the income level of the people living in Turkey.

So, we can conclude that the expansionary monetary policy is effective in increasing the output in an economy when the exchange rate is flexible..