Money Supply, Interest Rates, and the Exchange Rate
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What is the relationship between money supply, interest rate, and exchange rate?
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Solution Summary
This answer assist looks at the relationships between money supply, interest rates, and the exchange rate along with underlying reasons for these relationships.
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Money supply, interest rates, and the exchange rate all work together in the foreign exchange market. While interest rates and money supply generally have an inverse relationship, interest rates and exchange rates often have a positive relationship. Let's look at some reasons why.
First, let us begin with the interest rate. When I think about the interest rate, I often think of it as the (opportunity) cost of holding money. When it comes to taking loans, I think of it as more of a rental rate of money, or the cost of holding someone else's money. As the interest rate increases, the opportunity cost of holding your money increases. This means that as interest rates increase, you give up more interest dollars by holding your money as opposed to putting it in the bank. The same is true if the movement is in the other direction. As interest rates decrease, the opportunity cost of holding your money goes down. You give up less dollars in interest holding you money ...
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