According to Ch 18, 6.1, an increase in the money supply causes a reduction in domestic exchange rate. It gives three reasons:
1. some of the excess money will be spent on foreign assets, which will increase the supply of domestic currency and thus reduce the exchange rate.
2. interest rates will fall due to the increase in money supply, which means the demand for domestic assets will also fall, and hence the demand for domestic currency will fall.
3. speculators expect domestic currency to fall, so they sell the domestic currency and buy foreign currency.
It then says that all of these will result in an improvement in the balance of payments.
What I don't understand is surely each of those three points will principally lead to a worsening of the balance of payments position.
1. if excess money is spent on foreign assets, the balance of investments will get worse:
2. if interest rates fall, then foreign deposits will appear more profitable, and so there will be a worsening of the balance of other financial flows.
3. if speculators buy foreign currency, then that foreign currency may be used to purchase goods/services/investments outside of the country.
Why aren't any of these points discussed?
Thanks
Last edited by a moderator: Mar 29, 2012