Question

Prior to November 2007, the exchange rate between the U.S. Dollar (USD) and the Moroccan Dirham (MAD) was market determined, and the Bahraini Dinar (BHD) was pegged to the U.S. Dollar. The exchange rates stood at MAD8.2/USD and BHD0.3770/USD. The U.S. economy was expected to slow down during the early part of 2008, and so the Fed (U.S. central bank) was contemplating an expansionary monetary policy to provide some stimulus to the economy. Discuss the effects of a 4% increase in the U.S. money supply on the MAD/USD and the BHD/USD exchange rates. Clearly explain the effects using well labeled graphs for each exchange rate.

Answer 1

The rule is very simple, the increase in money supply of any economy results in its currency to depreciate, hence when the US economy increases the money supply in the economy the exchange rate will be in the favor of the company the US $ is compared to. In this case the market had decided the Moroccan Dirham while the Bharaini Dinar was pegged which means was fixed against the US $

In the case of increase in 4% of money supply the exchange rate of US $ decreases resulting in higher demand of dollar but the imports become expensive for US. On the other hand a pegged currency rate will be managed along with the depreciation of the US $. Hence the exchange rate for Bharain will be increased due to depreciating US $.

in the following graph with an increase in money supply the depreciation of the US $ takes place, due to this the demand for the dollar increases however the supply shifts from SS to S1S1. This reduces the price of the dollar as well from P1 to P2. and hence now the Moroccon Dirham will fetch more goods or imports at less dollar paid to the exports from US.