Question

Using the money market/foreign exchange market diagram, briefly explain how the AA curve will shift when there is an increase in money supply.

Answer 1

AA curve will shift to the right when money supply is increased. This is because monetary expansions causes the exchange rate to depreciate so that the value of exchange rate (measured in terms of foreign currency) rises and at the same time output rises as well.

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.