Question

If their is a temporary increase in the money supply of a home country (US), please graph (in order to show how the variables change) the following:

As an Example, lets use the US dollar and the Euro

Nominal money supply, price level, real money supply, United States’s interest rate, and the exchange rate  

Answer 1

A temporary increase in the level of money supply in an economy will shift the money supply curve rightwards in the money market to Ms' and the equilibrium moves from point E1 to point E2 in the money market. As the equilibrium moves from to this point, the rate of interest in the economy has decreased and quantity of money has increased. This is depicted in panel i of the diagram.

As rate of interest in the economy decreases, the cost of investment decreases and this increases investment expenditure in the economy shifting AD curve in the economy rightwards to AD' and equilibrium moves from point e1 to point E2 where rate of price level has increased. Since nominal money supply and price level has increased, the real money supply will remain constant.

In the foreign exchange rate, a decrease in rate of interest will cause Net capital Outflow from the economy and as the capital flows out , the demand of the home currency will decrease and this will lead to depreciation of home currency in the foreign exchange market.

Thus, it can be stated that a temporary increase in money supply will increase nominal money supply, increase price level, keep real money supply constant, reduce rate of interest and lead to depreciation of home currency.