Question

How each of the following changes will affect the exchange rate (dollars per euro) according to the monetary approach to exchange rates:

a.The US money supply increases.

b.The EU money supply decreases.

c.The US national income increases

d.The EU national income decreases.

Answer 1

a. The US money supply increases- When US money supply increases, it decreases the value of US dollar. US dollar devalues when supply of money increases, it loses its purchasing power, it gives birth to inflation that increases the price levels. US dollar devaluates in terms of Euro.

b. The EU money supply decreases- When money supply decreases in EU, purchasing power of Euro increases and inflation decreases and Euro appreciates in terms of US dollar.

c. The US national income increases- When US national income increases, people have more money to spend, they demand for more goods and services while supply of goods and services remain same so prices increase, it creates inflation in the economy and due to inflation and increase in money supply in the country, US dollar devaluates in terms of other currencies as well as in terms of Euro.

d. The EU national income decreases- If EU national income decreases, people will have less money to spend and they will not demand for new and more goods and services, supply remain constant then prices will come down, inflation will come down and it will appreciate Euro in terms of other currencies as well as dollar.