What are the effects of an increase in the money supply?

Answer 1

In the short run, because of price stickiness (wages and prices of because products are set in contract in a period of time so that they cannot change immediately in response to the money supply), real money supply Ms/P increases proportional to the rise in nominal money supply. There's an excess supply of money in circulation because money demand remains the same. Therefore, in order to lend the extra money in hand, people will offer lower interest, therefore the interest rate of the market is decreased.

As for foreign exchange market, because the rate of expected dollar return on dollar deposits decreases, other currencies deposits, say Euro deposits which offer a higher rate of dollar return, become more attractive. Thus people will buy more euro deposits and bid up the price of euros. As a result, the exchange rate of dollar against euro goes up, which means a depreciation of dollar against euro.

However, in the long run, things will be another story. Because there's enough time for workers to demand higher wages and for sellers to adjust their product prices, price stickiness doesn't exist and price level moves proportional to the increase of money supply. Hence, real money supply, which equals nominal money supply divided by price level, hasn't be affected. However, because the price level goes up and there's an inflation in the country, people will expect a further depreciation of US dollars against other currencies. According to interest parity theory, this will lead to a depreciation of US dollars. However, in the long run, money supply doesn't affect real output and interest rate given full employment and invest of all production factors.

Hope my answer can be useful. Perhaps you need to refer to "interest parity model".