Question

An increase in Money Supply will decrease the interest rate and increase the level of inflation in the domestic market

...An increase in Money Supply will decrease the interest rate and decrease the exchange rate (the rate at which currencies can be traded for one another)

I can't understand. Please explain this with a diagram.

Answer 1

(a)

Increase in money supply shifts money supply curve to right, decreasing interest rate and increasing quantity of money.

In following graph, MD0 and MS0 are initial money demand and supply curves, intersecting at point A with initial interest rate r0 and quantity of money M0. When MS0 shifts right to MS1, it intersects MD0 at point B with lower interest rate r1 and higher quantity of money M1.

Lower interest rate increases investment. Increase in investment increases aggregate demand, shifting AD curve rightward, increasing both price level (inflation) and real GDP in short run.

In following graph, initial equilibrium is at point A where AD0 (aggregate demand) and SRAS0 (short-run aggregate supply) curves intersect with initial equilibrium price level P0 and initial equilibrium real GDP Y0. When aggregate demand increases, it shifts AD0 rightward to AD1, intersecting SRAS0 at point B with higher price level P0 and higher real GDP Y1.

(b)

Higher money supply shifts LM curve rightward, decreasing interest rate. When interest rate decreases, net capital outflow increases. Since net capital outflow is equal to net exports, higher net capital outflow increases net exports, which decreases exchange rate (depreciating domestic currency).

In following graph, panel A shows IS and LM curves. IS0 and LM0 are initial IS and LM curves intersecting at point A with initial interest rate r0 and initial output Y0.

As money supply increases, LM0 shifts right to LM1, intersecting IS0 at point B with lower interest rate r1 and higher output Y1.

In panel B (showing net capital outflow as inverse function of interest rate), lower interest rate from r0 to r1 increases net capital outflow from NCO0 to NC01.

In panel C (showing net exports as inverse function of exchange rate), an increase in net capital outflow from NCO0 to NCO1 increases net exports from NX0 to NX1 and decreases exchange rate from e0 to e1.