Abstract
Not only money supply has an impact on an economy’s short run operations, but also in the long-term. Also, money supply in an economy, such as the United States of America, affects a number of macroeconomic factors, such as the exchange rates, as well as the inflation rate among many other variables.
Apparently, changes in the exchange rates have substantial influence on the long-term growth, as well as stability of the economy. This essay provides the analysis of the effects of changes in exchange rates.
Money supply, inflation and exchange rates
In brief, an up shift in the volume of money supply causes the cost of borrowing, which is also the interest rate to move downwards. Basically, this is because there will be excess money in circulation in the economy. Subsequently, households, will save surplus money in the financial institutions to take advantage of the high interest rate securities.
Following this increment in money supply, there will be pressure on the cost of borrowing, which will then move down, up to a different equilibrium state. In essence, this new state of equilibrium will indicate a lower interest rate as compared to the earlier one.
It is of a great significance to note that, since the cost of borrowing has moved downwards, it will be favorable for borrowers. In this case, both individual consumers together with corporate ones will find it friendly to borrow, and accordingly mark a step-up in the funds borrowed (Hornle, 2008).
Under these situations, expansionary measures relating to the money supply lead to better progress in the economy’s total income. On the other hand, the economy’s capability is on the investments’ reaction towards the adjustment in the cost of borrowing.
For example, if investments do not increase sufficiently even with low-interest rates, the effect of expansionary money supply then is minimal (Mankiw, 2011). In contrast, most firms invest more when the cost of borrowing is low. Generally, increased investments in factors of production demand that hiring of more workers be done, to boost the production levels.
However, if there are strong trade unions in an economy, there is a probability that they will demand higher wages, which will in turn increase the total cost of production, even as the level of production remains constant. Eventually, manufacturers and other business organizations will have to increase the prices of their products and services to meet the high cost of production (Mankiw, 2012).
According to Mankiw (2011), if the value of products records is an upward trend, the demand for money rises since the same amount of money has less value; one needs more dollars to buy the same goods and services. The direct outcome is a decline of the real money supply.
As the price level moves up, the purchasing power of the dollar decreases on a worldwide scale. For instance, the cost of all the goods imported to the United States of America will be higher as compared to its exports. Singularly, this is because domestically produced goods, together with services, will be cheaper. However, domestic products will be on high demand leading to an increase in price.
In the long run, it is contingent upon whether money supply fluctuations are long-lasting or temporally. Clearly, fluctuations in the exchange rate bring about uncertainty in the domestic, as well as foreign markets (Mankiw, 2011). This uncertainty impacts on the economy’s trade flows.
For instance, business organizations will indulge in the activities that will enable them to mitigate costs, such as doing way with some of the workers, and even reducing investment activities. Additionally, firms are likely to experience reduced real rates of return, which impacts the economy’s growth (Hornle, 2008).
In precise terms, whereas shifting trends in money supply influence the rate of inflation negatively, as well as the exchange rates in an economy considering their effect on the total output, it is critical that investors understand how the money market operates when making critical investment decisions.
Reference List
Hornle, D. (2008). The relationship between the money supply and the inflation rate and the role of the European Central bank in the changing money supply. Munich: GRIN Verlag.
Mankiw, N.G. (2011). Principles of macroeconomics. Mason, OH: South-Western, Cengage Learning.