Question

The UK has a floating exchange rate. Prices are flexible in the long run but sticky in the short run. Uncovered interest parity holds at all times. Purchasing power parity holds in the long run but not in the short run. The markets believe that the Bank of England is committed to long run price level stability.

a. Suppose that in response to Brexit, the decision of the UK to leave the European Community, the Bank of England decides to increase the money supply. What is the effect on the interest rate and exchange rate in the short and in the long run?

b. Suppose that in response to Brexit there is a positive risk premium for the British currency. In other words, investors now have to be compensated by a higher return if they are to invest in Britain. What are the effects on the exchange rate and the interest rate in the short and long run?

Answer 1

All else being equal, a larger money supply lowers market interest rates. Conversely, smaller money supplies tend to raise market interest rates. The current level of liquid money (supply) coordinates with the total demand for liquid money (demand) to help determine interest rates.

In a growing economy, having a money supply that increases over time can actually have a stabilizing effect on the economy. Growth in real output (i.e. real GDP) will increase the demand for money, and will result in an increase in thenominal interest rate.

The higher interest rates that can be earned tend to attract foreign investment, increasing the demand for and value of the home country's currency leading to an appreciation of currency.