Question

Use the interest parity equilibrium condition, along with a graph to explain and show why a permanent decrease in the money supply will result in a lower nominal exchange rate.

Answer 1

Interest rate parity equilibrium condition means there are no interest rate arbitrage opportunities. In other words, investors are indifferent to interest rates in two countries.

Now, it is given that there is a permanent decrease in the money supply. For a given level of income and interest rate, such a thing will put pressure on the interest rate to rise. This is because for a given level of income, decline in the money supply will result in higher demand of money for transaction purpose. As a result, people will start to withdraw money from their speculative balances. So, in order to keep the money market in equilibrium the interest rate will rise.

Rise in the interest rate will result in capital inflow as foreign financial investors will invest to take advantage of higher interest rate. This will put pressure on the exchange rate to appreciate or in other words the nominal exchange rate will decline.

This is because investors will demand domestic currency for investment because of which the demand for domestic currency will increase while the supply of foreign currency will increase.