Friday, December 29, 2006

Higher Money Supply Growth-Stronger Currency

The ECB reported that money supply (M3) growth rose to a record high 9,3% in November. The market reaction? The euro rose against the dollar, the yen and the pound.

This mirrors the market reaction to higher than expected U.K. inflation numbers, which lead to a stronger pound.

These reactions may seem strange given the common sense view that a higher supply of a currency will lead to a lower price of it. But this assumes that demand for the currency is unchanged. And as higher money supply growth will likely cause the ECB to raise interest rates more, demand for European securities is likely to rise.

In the long run, we should still expect the currency to fall as the increase in demand for European currencies is not likely to permanently increase as a result of this. But today's foreign exchange markets clearly cause a lot of distortions that means currency value deviate from purchasing power parity even of traded goods.


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