Question

Consider the monetary model of the exchange rate. Using the equations EH/F = PH / PF and P = M / L∗Y state what happens to the home currency when there is

a) an increase in foreign real income

b) an increase in the foreign money supply

c) an increase in the domestic demand for money

You should use the words ’appreciate’ or ’depreciate’.

What do these equations look like when you transform them into growth rates?

Answer 1

a. An increase in the level of foreign income leads to increase in the demand for exports of the nation. As the exports of the nation increases, demand for home currency will increase. An increase in the demand for home currency leads to appreciation of the home currency.

b. When the foreign money supply increases, then interest rate in the foreign currency will do down and as the rate of interest in the foreign currency decreases, the return on investment on the foreign currency will decrease as compared to the home currency where rate of interest are still higher. Thus, demand for home currency will increase and demand for foreign currency decreases leading to appreciation of home currency vis-s-vis foreign currency.

c. An increase in domestic demand for money in the money market leads to increase in the rate of interest in the money market. An increase in the rate of interest in the money market leads to appreciation of home currency with respect to foreign currency.

when transforming into growth rate, the equation looks like -

Growth rate in Money Supply + Growth rate in Velocity = Growth rate in Price level + Growth rate in Output.