Question

Which one of the following statements is the MOST accurate?

(a) A permanent increase in a country’s money supply causes a proportional long-run depreciation of its currency against foreign currencies.

(b) A temporary increase in a country’s money supply causes a proportional long-run depreciation of its currency against foreign currencies.

(c) A permanent increase in a country’s money supply causes a proportional long-run appreciation of its currency against foreign currencies.

(d) A permanent increase in a country’s money supply causes a proportional short-run depreciation of its currency against foreign currencies.

(e) A permanent increase in a country’s money supply causes a proportional short-run appreciation of its currency against foreign currencies.

Answer 1

In the above options, option (a) is the most accurate - A permanent increase in a country's money supply causes a proportional long-run depreciation of its currency against foreign currencies.

This is due to the following turn of events when money supply is increased - as money supply increases, the real interest rates decline. This makes domestic financial and capital assets less attractive. Foreigners thus reduce their positions in domestic bonds, stocks and other assets. Domestic investors will also more likely invest overseas to get higher rates of return. This reduction in domestic investment by both foreigners and citizens will lead to decrease in the demand for national currency and increase the demand for foreign currency. This thus leads to decline in the exchange rate of the nation's currency.