Question

Please show the model and explain the quantity theory of money and how changes in the money supply can affect the FX rate.

Answer 1

Solution:

The quantity theory of money: This theory states that the money available growth will be the same as growth in the price level in the long run.

Model: M x V = P x Q

M = Money supply

V = Velocity of money

P = Price level

Q = Quanitity

Suppose Q and V are constant then the increase in money supply will increase the price levels.

According to purchasing power theory, this increase in the price level will influence the exchange rate, and when money supply increases then the exchange rate increase or we can say that the home currency depreciates. Similarly, when money supply decreases then the exchange rate decreases or home currency appreciates.