Question

Suppose the Federal Reserve, perhaps fearing the onset of a recession, initiates a looser monetary policy and raises the U.S. money supply. What effect will these actions have on the dollar in the foreign exchange market?

*Please answer in DETAIL*

Answer 1

US money supply is increased. This shifts the money supply curve Ms/P to the right, resulting in a reduction in the rate of interest from R1$ to R2$ in US money market. There is a movement of equilibrium from A to B where now real money balances are increased and rate of interest is reduced.

In foreign exchange market, reduction in domestic rate of interest allows investors to look for other currencies such as pound which have a relatively higher rate of interest. They start converting their dollars into pounds which implies that the expected return on pound deposits rises and dollar depreciates. This is shown as a movement from A to B in foreign exchange market where exchange rate rises from E1 to E2.

Hence, a monetary expansion results in currency depreciation.