Money supply in an open economy

Money supply in an open economy

So far our discussion is based on a closed economy.
In an open economy the domestic money supply can be affected
depending on the type of exchange rate system the country
is on.

Flexible Exchange rate system
Under a flexible exchange rate system, the country’s balance of
payment will always balance. Should the country experience a
balance of payment surplus for example or a situation of an
an excess supply of foreign currency (or an excess demand for
domestic currency), the domestic currency will appreciate vis-à-vis
the foreign currency. The appreciation makes domestic goods more
expensive and imported goods cheaper resulting in a decline in
domestic X and an increase in imports.

In a flexible exchange rate
ssystem, a surplus in the balance of payment results in an
appreciation of the domestic currency which then eliminates the
surplus. Vice versa had we started off with a balance of payment
deficit , the excess demand for foreign currency (or excess supply
of domestic currency) would have resulted in a depreciation of the
domestic currency vis-à-vis the foreign currency.

This now makes domestic goods cheaper relative to imports. The increase in net
exports therefore reduces the deficit in the balance of payment.
Since the balance of payment always balances through the
adjustments in the exchange rate, there will be no effect on the
domestic money supply.