Money Supply Growth and Exchange Rate

Money Supply Growth and Exchange Rate

The purpose of this paper is to re-examine the issue of exchange rate dynamics when the central bank undertakes a change in the growth rate of the money supply. The original analysis of exchange rate dynamics, the seminal model of Dornbusch, assumed that the growth rate of the money supply was zero and that the central bank permanently changed the money stock. In reality, however, central banks typically maintain money supply growth targets rather than money stock targets. Therefore, it seems appropriate to re-examine the issue of exchange rate dynamics using the money supply growth rate as the central bank`s policy instrument. The paper analyzes the problem using a variable output version of the Dornbusch model. Perhaps the most significant finding in the paper is that money supply growth causes the exchange rate to either overshoot or undershoot. In addition, the real exchange rate depends inversely on the real interest rate during part of the adjustment process, in contrast to the real interest dif ferential model. (JEL Classification: F41)