Question

Consider the asset model of the exchange rate. What is the difference between the effect of a temporary increase in the money supply versus the effect of a permanent increase in the money supply? Be specific and describe in detail.

Answer 1

Central banks determine the money supply. In the US, the central bank is the Federal Reserve System. The Federal Reserve directly regulates the amount of currency in circulation, as well as banking system reserves. It indirectly controls the amount of checking deposits issued by private banks.An increase in a country’s money supply causes its currency to depreciate. A decrease in a country’s money supply causes its currency to appreciate. (Note: These statements are based on the policy experiment in which we hold the future expected exchange rate Ee$/€ constant.)