Money supply: Money Supply in an Open Economy
The causes and effects of increased monetary growth are radically modified once we open an economy to inflows and outflows of capital from abroad. If the exchange rate is fixed and foreign currency can readily flowinto and out of the country, interest rates will not fall except in the very short run. This is simply a manifestation of the ‘‘impossible trinity’’ mentioned earlier. Any attempt by a central bank to increase monetary growthwill result in asmall and short-lived decrease in short-run interest rates that will cause foreign currency to flow out until the increase in monetary growth is reversed. Since the central bank is committed to a fixed exchange rate, itwill sell enough foreign currency to accommodate the outflow, and in the process itwill buy domestic currency, thereby taking it out of circulation. Interest rates (risk adjusted) will remain unchanged, at ‘‘world’’ levels.
Finally, it is important to understand the effects of themoney supply on the exchange rate if it is not fixed by the central bank. Briefly, if and when an economy’s factors of production are fully employed, a permanent increase in monetary growth will, in the long run, increase the nominal domestic-currency value of foreign currency but leave the ‘‘real’’ value unchanged. A permanent increase in monetary growth is accompanied by a permanent increase in inflation. The country will gradually price itself out of export markets unless it offers an increase in domestic currency per unit of foreign currency equal to the increase in its inflation rateminus any increase in its trading partners’ inflation rates. This leaves the ‘‘real’’ exchange rate unchanged.
In short, the rate of growth of a country’s money supply is the crucial determinant of its long-run inflation rate. It is also a determinant of short-run interest rates, short-run exchange rates, and short-run rates of output growth.Whether central banks can or should attempt to control short-run interest rates, exchange rates, and output growth by manipulating money supplies is a matter of both theoretical and policy controversy. Indeed, the controversy is moot for central banks that are committed to fixing their exchange rates, since in a world with globalized capital flows they simply have little or no control over their own money supplies.