One of the questions that forex traders most frequently ask themselves is the following: how does the euro-dollar exchange rate change when the Federal Reserve or the European Central Bank change their money supply?
The answer is quite simple. Suppose, for example, that the Federal Reserve increases the US money supply. This increase has the following effects: 1) an excess of money supply is created, given the initial interest rate in the US market; the interest rate on the USD must therefore decrease towards a new equilibrium level. 2) as the expected rate of return on deposits denominated in EUR is higher than that on deposits denominated in USD, the holders of the latter will try to sell them against EUR-denominated deposits, which are more profitable. 3) the USD depreciates as soon as the owners of USD-denominated deposits try to exchange them for EUR-denominated deposits. The depreciation of the USD against the EUR (i.e. EURUSD appreciates) causes a reduction in the expectations of the traders on the future depreciation rate of the greenback, to an extent equal to offset the reduction in the interest rate for the USD.
The conclusion that can be drawn, useful for those who negotiate any exchange rate, is as follows: an increase in a country’s money supply causes a depreciation of that country’s currency on the forex market. Similarly, a reduction in a country’s money supply leads to an appreciation of its currency on the forex market.
The conclusions drawn can obviously also apply if the ECB changes its money supply in the Eurozone. An increase in the money supply causes a depreciation of the EUR (i.e. an appreciation of the USD and a decrease in the EURUSD), while a reduction in the money supply will produce an appreciation of the EUR.