Question

Consider two countries, Home and Foreign, with variables in Foreign denoted by asterisks ("*"). Let Y = 2,000, M = 400, P = 1.25; and Y* = 1,500, M* = 300, P* = 2.00. Suppose the demand for liquidity takes the same form in both countries, that is, L(R, Y) = L* (R, Y) = 2Y/100R (notice that the functions have the same form, but in each country the values of Y and R are different). (Advice: once again, don't just compute a number, but try also to sketch a graph.)

3. If Home doubles the money supply to M = 800, and agents don't change their expectation about the future exchange rate what happens to the exchange rate in the short run (use four decimal spaces)?

Answer 1

Increase in Money Supply:

An increase in money supply lowers interest rate, given price level and output. An increase in a country's money supply causes its currency to depreciate in the foreign exchange market. Investment inflows from across the world are affected by interest rates, which represents the returns on their investments. If interest rates in a home country are low, there will be less investment flowing into that country, due to it being possible to earn a higher return in other markets with higher interest rates. This means that there is less demand for the currency of home country. If there is less demand for something, the price of that thing tends to fall. Since the exchange rate is the price of currency, this means that home currency should fall, i.e. it will depreciate against other currencies, leading to a higher exchange rate of Home Currency/Foreign Currency.

So, to summarise:

• Lower interest rates mean less investment inflows
• Lower investment inflows means less demand for Home currency
• Lower demand for the currency causes it to depreciate
• The exchange rate becomes higher

Future Expections:

One reason to demand a currency on the foreign exchange market is the belief that the value of the currency is about to increase. One reason to supply a currency—that is, sell it on the foreign exchange market—is the expectation that the value of the currency is about to decline.

When foreign investors expect a home currency to strengthen in the future, they buy the currency and cause it to appreciate immediately. The appreciation of the currency can lead other investors to believe that future appreciation is likely—and thus lead to even further appreciation. Thus, beliefs about the future path of exchange rates can be self-reinforcing, at least for a time, and a large share of the trading in foreign exchange markets involves dealers trying to outguess each other on what direction exchange rates will move next.

Demand for the home currency shifts to the right, from D₀ to D₁, as investors become eager to purchase home currency. Conversely, the supply of home currency shifts to the left, from S₀ to S₁, because investors will be less willing to give them up. The result is that the equilibrium exchange rate rises from 1.25 /400 to 2.5/800 as the equilibrium moves from E₀ to E₁.