Now we need to derive the relationship between the exchange rate and output ( the DD schedule) when the output market is in equilibrium. To do this consider. exchange rate dynamics using the money supply growth rate as the central . relationship, rising output must lead to rising wage increases and hence. 5. PDF | Growth rates, inflation and interest rates are determined Impact of exchange rate and money supply on growth, inflation and interest rates in the UK . These correlations just indicate that cause–effect relations in.
Lower interest rates — to make it cheaper to borrow and encourage both consumption and investment. Increasing the money supply, e. This is for two main reasons: Everything else being equal, an increase in the money supply is likely to cause inflation.
This is because with more currency chasing the same quantity of goods, firms will respond by putting up prices. See why an increase in the money supply causes inflation Alternatively, if expansionary monetary policy involves cutting interest rates — lower interest rates will tend to increase aggregate demand leading to possible inflationary pressure. Effect of lower interest rates This domestic inflation will make your goods relatively less competitive and export demand will fall.
Therefore, there will be less demand for the currency and its value will tend to fall on the exchange rate markets.
Also, if you increased the money supply, through a Central Bank creating more moneythen this reduces interest rates.
Higher money supply puts downward pressure on interest rates. Lower interest rates will also tend to reduce the value of the currency. If UK interest rates fall relative to elsewhere, it becomes less attractive to save money in UK banks.Money supply and demand impacting interest rates - Macroeconomics - Khan Academy
This will put downward pressure on the currency as people sell Pounds to buy other currency. Why expansionary monetary policy may not cause depreciation The Pound fell rapidly in to early during the start of the credit crunch and great recession. But the Pound recovered in the period — despite expansionary monetary policy and quantitative easing in this period.
It is of fundamental importance because every time domestic residents want to buy something abroad they must exchange domestic currency for foreign currency, and every time foreigners want to buy domestic goods they must exchange foreign currency for domestic currency.
The exchange rate has an important relationship to the price level because it represents a link between domestic prices and foreign prices. For example, ignoring taxes, subsidies and shipping costs, the price of wheat in Canada must equal the exchange rate price of the U. This relationship is called the law of one price.
If every good produced in the domestic economy is also produced in the foreign economy, and if the shares of each good in aggregate output are the same in both economies, then the domestic price level will equal the exchange rate times the foreign price level.
The Exchange Rate and the Price Level
Suppose that the government decides to fix the price of its currency in terms of some foreign currencythat is, adopt a fixed exchange rate. By fixing the exchange rate, the domestic authorities tie their hands with respect to monetary policythey are forced to create a specific equilibrium nominal money supply.
As a matter of policy, the government can control either the domestic money supply or the country's exchange rate but not both. When the government fixes the exchange rate, it invokes a natural mechanism that keeps the domestic money supply at its equilibrium level. In order to fix the exchange rate, the government must stand ready to purchase or sell domestic currency for foreign currency at its announced price.
Money supply and the exchange rate
If the domestic money supply is too high, people will spend the excess abroad, buying foreign currency with home money to enable those purchases. This will cause the price of foreign currency in terms of domestic currency to be bid up.
To maintain the exchange rate at the official level, the government has to sell foreign currency for domestic currency, taking home money out of circulation in the process.
For the purpose of doing this, it keeps reserves of foreign currency on handthe country's stock of foreign exchange reserves. If the domestic money supply is too low, the opposite will happen. Too much will be sold abroad and people will be exchanging too much foreign currency for domestic currency.
The government has to buy foreign currency to keep the price of foreign currency in terms of domestic currency from falling below the official level. This increases the country's stock of foreign exchange reserves and puts additional domestic money in circulation. The government can choose, of course, to not purchase and sell foreign currency for domestic currency when there are excess sales or purchases by domestic residents abroad.
In the analysis in the other Topics in this Lesson, we always assume flexible exchange rates. This enables us to think about domestic money and prices without worrying about what is happening in the rest of the world. We will be four Lessons further along in the sequence before we look again at exchange rates, and a full understanding of how they are determined and their relationship to domestic economic policy will only emerge with completion of the entire sequence of Lessons.
Nevertheless, before concluding this present Lesson we need to discuss further the law of one price and the relationship between the domestic and foreign price levels. In order to write down Equation 2 we had to assume that all goods are produced everywhere and can be freely bought and sold across international boundaries without the impediment of transport costs, tariffs, taxes, or subsidies, so that Equation 1, the law of one price, holds for every good.