This diagram mainly shows the reaction and interaction between two markets-domestic money market (also called domestic money market) and foreign exchange market (FX market) when the money supply (MS) changes.
(a) domestic money market
The relationship between money supply and interest rate;
Part (a) of the figure shows that in the domestic money market, when the money supply (MS) increases, the domestic interest rate (rN) will decrease. This is because the increase of money supply makes the funds in the market more abundant, and the borrowing cost decreases, which leads to the decline of interest rates.
The "expected return (MS) decreases with the increase of interest rate" mentioned here may be misleading or simplified, because the relationship between expected return and interest rate is not directly determined by the money supply, but by the future cash flow and discount rate (interest rate) of investment projects. But in this picture, our main concern is the direct impact of money supply on interest rates.
Stability of real income (MD):
It is pointed out in the figure that although the change of money supply has affected the interest rate, the real income (MD) of the domestic money market has not been affected. The actual income here may refer to the actual purchasing power or value of money or financial assets held by people, which may fluctuate due to inflation, commodity price changes and other factors, but it is simplified as not directly affected by the money supply in this figure.
foreign exchange market
Money supply and expected return in foreign exchange market;
In the foreign exchange market, the increase of money supply reduces the expected return of the foreign exchange market. The "expected return" here may refer to the expected rate of return that foreign investors can obtain by holding their own currency or assets. Due to the increase of money supply, the purchasing power of domestic currency has decreased relatively, thus reducing the attractiveness of foreign investors to hold domestic assets.
Exchange rate fluctuations and currency depreciation;
The foreign exchange market is also affected by exchange rate fluctuations. When the domestic money supply increases, due to the increase of the domestic money supply in the market, the value of foreign money will decrease, that is, currency depreciation (DR). This devaluation not only affects the purchasing power of domestic currency in the international market, but also may trigger a series of economic and financial reactions such as deterioration of terms of trade and capital outflow.
Decline in real income:
As the chart shows, the real income (DR) of the foreign exchange market has also declined. The actual income here may refer to the net income obtained by foreign investors after considering exchange rate changes. Due to the devaluation of the currency, the amount that foreign investors can get when converting their own currency back into their own currency is reduced, thus reducing their real income.
The second picture:
Domestic money market (domestic money market)
Increase in money supply (ms):
When the domestic money supply increases, the amount of money circulating in the market increases, which leads to the reduction of borrowing costs.
This directly led to the decline of * * interest rate (RR)**, because the funds became more abundant, and the interest that borrowers needed to pay decreased.
However, the * * expected rate of return (EPR)** remains unchanged, probably because the market expectation has taken into account the change of money supply, or the expected rate of return is greatly influenced by other factors (such as economic growth and investment risk).
Market balance:
Although the money supply increased and the interest rate decreased, the overall balance of China's money market (that is, the balance between money demand and supply) remained unchanged. This is because the automatic adjustment mechanism of the money market is at work, including the adjustment of investors' asset portfolio and the adjustment of enterprises and individuals' lending behavior.
Foreign exchange market (forex market)
A temporary increase in foreign currency supply;
When foreign countries (such as the euro zone) temporarily increase the money supply, it will directly affect the economy of the euro zone.
The increase of money supply in the euro zone will lead to the decrease of interest rate in the euro zone, because the increase of money supply reduces the borrowing cost.
Exchange rate changes:
At the same time, the increase of foreign currency supply makes the supply of foreign currency (such as euro) increase relative to local currency (such as US dollar).
This usually leads to the depreciation of foreign currency and the appreciation of local currency, but the words in the picture refer to "the appreciation of the dollar", which seems to be contrary to the conventional economic theory. However, this may be due to specific market conditions or policy intervention.
However, from the perspective of economic principles, the increase of foreign currency supply is more likely to lead to the depreciation of foreign currency, rather than the appreciation of local currency. Therefore, "dollar compliment" may be a special case or a hypothetical situation here.
Expected rate of return and exchange rate:
The equations and relationships mentioned in the figure (such as the ratio of money supply to money demand and the relationship between exchange rate and expected rate of return) are the key to understanding the dynamics of foreign exchange market.
These relationships show that the changes in the foreign exchange market are not only affected by the money supply, but also by many factors, such as market expectations, investor behavior, policy intervention and so on.
The third picture:
summary
This chart shows the short-term impact on the money market and foreign exchange market when the US money supply (MS) is expected to increase permanently. The reactions of short-term money market and foreign exchange market are described respectively through two sub-graphs (a) and (b).
Short-term money market
It is expected that the money supply in the United States will rise permanently: this expectation will reduce the demand for money in the market, because people expect more money to circulate in the future.
Decline in domestic rate of return: due to the increase in money supply, funds become relatively abundant, which reduces the borrowing cost, that is, the domestic rate of return (such as interest rate) decreases.
Lower interest rate: lower domestic rate of return directly leads to lower nominal interest rate. This is reflected in the market, which is manifested in the reduction of borrowing costs and the increase of capital supply.
Short-term foreign exchange market (FX market)
The impact of the permanent rise in the US money supply: This change not only affects the domestic market, but also affects the international market through the foreign exchange market. When foreign investors see an increase in the US money supply, they may expect the US currency (such as the US dollar) to depreciate.
Increase in foreign money supply: Although the picture does not directly explain the reason for the increase in foreign money supply, it can be inferred that this is a reaction of the market to the increase in American money supply. Foreign countries may adopt corresponding monetary policies or market forces to promote the increase of their own money supply in order to maintain exchange rate stability or cope with other economic factors.
Exchange rate decline: As the market expects the depreciation of the US dollar, this will lead to a decline in the exchange rate (that is, the depreciation of the US dollar). The falling exchange rate made the foreign currency appreciate against the US dollar.
Overshooting phenomenon: The "overshooting" mentioned in the figure means that the exchange rate may be excessively adjusted in the short term, that is, the exchange rate changes exceed the long-term equilibrium level. This is usually due to the expected overreaction or information asymmetry of the market.
The fourth picture:
This picture discusses the long-term response of two markets-domestic money market and foreign exchange market to the continuous increase of money supply. It analyzes the changes of key economic variables such as price level, expected future interest rate, exchange rate and real money balance.
Domestic money market (long-term: money market)
The sustained growth of money supply:
It is pointed out in the figure that the domestic money supply (MS) continues to grow. This means that the central bank injected more money into the economy through monetary policy means (such as buying government bonds and reducing the deposit reserve ratio).
Price level rises:
In the long run, with the increase of money supply, the price level (P) will rise. This is because more money is chasing relatively limited goods and services, which leads to a general rise in prices, that is, inflation.
The interest rate returns to the original level;
Although the interest rate may be lowered at the beginning of the increase of money supply (because funds are more abundant), in the long run, with the increase of price level, the real interest rate (that is, nominal interest rate MINUS inflation rate) will return to the original level. This is because the economic system will automatically adjust to restore balance.
Decrease in real money balance:
When the price level rises and the purchasing power of money decreases, the real money balance (MD/P) will decrease. This means that the real value of money held by people has decreased.
Foreign exchange market (long-term: foreign exchange market)
Expected future exchange rate:
It is mentioned in the figure that although the foreign interest rate (FR) is expected to remain at a high level, the foreign exchange market will eventually be adjusted to reflect the new economic reality.
Dollar exchange rate rises:
In the long run, the exchange rate of the US dollar against other currencies (E/P*, where P* is the foreign price level) will rise, that is, the US dollar will appreciate. This may be because foreign economies have also been affected by a similar increase in money supply, but to a lesser extent, or foreign economies are relatively weak, leading to the depreciation of foreign currencies.
Real rate of return:
Although the foreign interest rate (FR) is still nominally high, due to the influence of exchange rate changes and inflation, the real rate of return (DR) of the US dollar will eventually return to its original level. This means that after considering the exchange rate risk and inflation factors, the actual return on investment at home and abroad is equal.