Effect of Increase in Money Supply on Exchange Rates

What is the effect of an increase in the money supply on exchange rates? An increase in the money supply leads to a decrease in interest rates and causes the exchange rate to fall. When the Reserve Bank of Australia increases the money supply in Australia by 30% at time t=2, it results in a decline in the value of the Australian dollar relative to other currencies, such as the Euro.

The Relationship Between Money Supply and Exchange Rates

Money supply refers to the total amount of money available in an economy at a particular point in time. When the money supply increases, there is more money circulating in the economy, leading to changes in interest rates, inflation, and exchange rates.

Impact on Interest Rates and Exchange Rates

When the money supply increases, interest rates tend to decrease. Lower interest rates make borrowing cheaper and encourage spending, which can stimulate economic activity. However, the decrease in interest rates also makes the local currency less attractive to foreign investors, leading to a depreciation of the exchange rate.

Anticipated Policy Change and Exchange Rate Adjustment

When the Reserve Bank of Australia announces an increase in the money supply at time t=2, individuals and market participants anticipate this change in advance. As a result, the exchange rate of the Australian dollar against the Euro is likely to start depreciating even before the actual increase in money supply occurs.

Short-Term and Long-Term Effects

In the short run, the exchange rate will immediately respond to the increased money supply, causing the Australian dollar to depreciate. By time t=2, when the policy change takes effect, the exchange rate will have declined even further. This leads to E$/€ being greater than 1.3 at both time t=1 and t=2. However, in the long run, the exchange rate is expected to stabilize around 1.3, reflecting the new equilibrium between supply and demand for the currencies.

Conclusion

An increase in the money supply in Australia has a direct impact on the exchange rate between the Australian dollar and the Euro. The anticipated policy change and flexibility of prices in the short run contribute to the depreciation of the local currency. Understanding the relationship between money supply and exchange rates is essential for predicting and analyzing economic developments in a global market.

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