Question

Under the monetary approach to exchange rates, if there is a rise in a country's home money supply and, ceteris paribus, then the exchange rate should:

a. depreciate.

b. hold steady.

c. appreciate.

d. appreciate and then remain steady.

Why? Explain intuitively and show your work by using “monetary approach to exchange rates” model.

Answer 1

Under the monetary approach to exchange rates when domestic or country's home mone supply increases then the exchange rate will (a) depreciate.
Under the monetary approach the exchange rate is directly related to the purchasing power parity (PPP).One of the important predictions of this approach is that the monetary policy will affect the exchange rates.Increased money supply will lead to inflation.This will cause the exchange rate to depreciate.When there is an increase in money supply an effect known as the magnification effect will take place.Due to inflation the real demand for money will fall .This causes the exchange rate to depreciate.

The monetary approach to exchange rate model:
The major assumptions are i) AS curve is vertical as shown in the figure.ii)real money demand is a function of real income iii)there is purchase power parity shown as p=sp* in the figure
When the money supply increases under the fixed exchange rate regime due to increased money supply there is an increase in AD.It will also increase the prices in the domestic market and will make them more uncompetitive.Thus the central bank will reduce the foreign exchange reserves.Thus whenever there is an increase in money supply there is decrease in foreign exchange reserves and will keep the money supply constant.