Question

Q) Under the monetary approach to exchange rates, if real money demand is greater at home but relative money supply is greater in foreign markets, then the exchange rate should be:

The answer is less than 1, but I think we cannot say anything about the value of the exchange rate itself. We can say the exchange rate will appreciate, so the rate of change can be less than 1. However, why can we conclude that the exchange rate itself is less than 1? For example, if the exchange rate of Japanese yen in terms of dollars is 100 yen/$, which is greater than 1, the condition of the above question can still hold.

Answer 1

If real money demand is greater at home but relative money supply is greater in foreign markets, interest rate in home is relatively higher than in foreign market. This will attract new investments in the home country. Again, this would cause interest rates to fall in the home country (owing to inverse relation between investment and interest rate). Home currency must depreciate. Exports will become cheaper and imports will be costlier. Thus, net exports will rise. As a result, exchange rate will become less than one (but we cannot find the exact value from the given details) .