Question

1. 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

Answer 1

When the bank of Turkey increases the money supply it will lead to depreciation of the Turkish currency through two channels. First, when the money supply increases it will lead to lower interest rate which will increase the output level and income level in the economy, therefore, we can expect the inflation to take place because of the higher level of income which will lead to increase in the aggregate demand. As the inflation increases in the Turkish economy it will make the Turkish goods less competitive in the international market and also Turkish people will demand more of the foreign goods, because Turkish goods are expensive now, which will lead to the depreciation of the Turkish currency because the Turkish people need to pay for the foreign goods in terms of the foreign currency. Secondly, as the interest-rate decreases in the Turkish economy, investors will move their money out of the Turkey and put or invest in the foreign country in search for the higher return, therefore, the demand for foreign currency will go up as investors have to pay in terms of the foreign currency which will lead to the depreciation of the Turkish currency.