Question

What is the relationship between money supply, interest rate, and exchange rate?

Answer 1

• When money supply increases in the economy people have more money in their hands as the banks lend more money as they have excess reserves, this causes the inflation to increase and the interest rates fall.
• Similarly when the money supply decreases in the economy, amount of researves decreases and the bank's decrease their lending, this causes the inflation rates to fall while the interest rates increases.
• This shows that there is an inverse relationship between money supply and interest rates.
• There is again an inverse relationship between money supply and the exchange rate. That is when money supply increases the exchange rate depreciates and when the money supply decreases the exchange rate appreciates due to two main reasons:-

1. Inflation:- When money supply increases the inflation rate increases, and the price's sore up. This decreases the demand for goods and services and the value of money decreases causing the exchange rate to depreciate and vice versa when money supply decreases.

2. Interest rates:- when money supply increases, the interest rates falls. Lower interest rates lower the value of a currency and vice versa.