CFA Level II ExamEconomicsEasy
A country, 'Veridia,' is a small, open economy that has recently experienced a significant increase in its money supply due to aggressive quantitative easing. Assuming perfect capital mobility and a flexible exchange rate regime, which of the following is the most likely long-term effect on Veridia's exchange rate?
- AThe exchange rate will initially appreciate then depreciate to its original level.
- BThe domestic currency will appreciate.
- CThe domestic currency will depreciate.
- DThe exchange rate will remain unchanged.
Show answer & explanationAnswer & explanation
Correct answer: C. The domestic currency will depreciate.
Under a flexible exchange rate regime with perfect capital mobility, an increase in the money supply leads to lower domestic interest rates, causing capital outflows and a depreciation of the domestic currency. In the long run, this depreciation is expected to persist as the increased money supply leads to higher domestic prices.
Why the other options are wrong
- A. While there might be short-term dynamics, the long-term effect of increased money supply under these conditions is depreciation, not a return to the original level.
- B. An increase in money supply typically leads to lower interest rates and capital outflows, causing depreciation, not appreciation.
- D. The exchange rate will change in response to monetary policy under a flexible regime.
Monetary Policy and Exchange Rates (Flexible)
Under a flexible exchange rate regime with perfect capital mobility, an increase in the money supply leads to lower domestic interest rates, capital outflows, and depreciation of the domestic currency.
- Flexible exchange rate allows currency value to fluctuate.
- Perfect capital mobility means capital moves freely across borders.
- Increased money supply lowers domestic interest rates.
- Capital outflows occur as investors seek higher returns abroad.
- Domestic currency depreciates as a result of capital outflows.
Memory trick: Money floods in, value flows out, flexible markets show the route.