Both US and Europe have increased money supply to mitigate the devastating effect of COVID-19 on economy
Traditional economic theory posits that when there is more supply than demand, then the price of goods decreases, and vice-versa. The same logic applies to the value of currency: if there is more USD than Euro, then the value of USD should depreciate against the value of Euro.
Let’s see what is happening to the USD/Euro foreign exchange rate.
M3 in USA, Europe and USD/Euro foreign exchange rate
Source: Board of Governors of the Federal Reserve System
Note: 1) M3 is a measure of the money supply that includes M2 as well as large time deposits, institutional money market funds, short-term repurchase agreements and larger liquid assets.
Generally, this chart shows that the value of Euro has appreciated against USD (green line is going upward). But USD money supply increased greatly from a year ago since 2009 (red line in 2020), surpassing the increase in Euro money supply (blue line in 2020).
M3 for both US and Europe is on the rise compared to a year ago in 2020 due to COVID-19, but the increase for Europe is about 6% while that of US is 23%. If this is the case, then USD must significantly depreciate against Euro.
Indeed, the USD/Euro foreign exchange rate does show depreciation of USD against Euro, but its magnitude pales when compared to how much USD money supply has increased.
Why is that? There are some potential explanations:
- Perhaps, there are other factors at play, such as the demand is high for the greenback, the only global international key currency, in case of another liquidity crisis due to COVID-19.
- More USD money supply has been or is waiting to be absorbed by stock market than Euro, diluting the effect of the increase in M3.
- Foreign exchange is not solely determined by the currency in circulation, and there are many variables at play, such as economic growth (US economy recovering faster than EU area).
Whatever the reasons are, USD is going to suffer and decline in its value compared to Euro in the short-run, if the traditional economy theory that more supply leads to lower price holds true.
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