An increase in money supply raising expectations of inflation is likely to depreciate the current exchange rate. This effect is expected to occur in two ways: through pressure exerted on inflation and interest rates. An increase in money supply is likely to raise the inflation rate and the prices of goods and services in a country. With the rise in prices, domestic goods of one country may be less competitive than its counterparts, thus reducing the domestic currency’s demand and value in the current exchange rate market. Similarly, an increase in the money supply may lower the interest rates, making foreign saving more attractive than domestic saving, as shown in figure 1. The low interest rates may also reduce the domestic currency’s exchange rate value as more money would be required to buy a foreign currency.
Figure 1.
As seen from the diagram, an increase in the money supply of dollars makes savings in pesos more attractive, leading to a decrease in the demand for US dollars from D0 to D1.
An increase in trade barriers is likely to raise the current foreign exchange rate, as shown in figure 2. This effect mainly stems from the rise in the value of one country’s currency relative to another. For example, if the United States imposes a 10 percent tax tariff, the value of imports into the country becomes more expensive, and the exporters would require more cash to exchange for the US dollar.
Figure 2
As seen in diagram 2, an increase in trade barriers increases the demand for dollars from D0 to D1 because of the higher value of this currency among importers.
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