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Imagine a country experiences a higher money supply growth rate, and so higher inflation, than other...

Imagine a country experiences a higher money supply growth rate, and so higher inflation, than other countries, year after year. Explain what would happen to the following over the long-run: (1) the nominal exchange rate, (2) the real exchange rate.

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Answer #1

When money supply increases, the country experiences inflation.

1. Nominal exchange rate is the number of units domestic currency that are needed to purchase 1 unit of foreign currency. So, it expresses the external value of home currency. When inflation ocurrs it has no effect on home currency. So, nominal exchange rate will be unaffected

2. Real exchange rate is the price of foreign goods relative to the price of domestic goods. So it is the ratio of foreign price level to domestic price level multiplied by nominal exchange rate. So, when inflation occurs, price level increases for home country so, real exchange rate decreases, i.e appreciation occurs without changing external value of the home currency.

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