Relationship between Money Supply, Price Level and Exchange Rate

Abstract

According to the quantity theory of money as the money supply increases price level in the country also increases in the same proportion. Since prices of all goods and services increase the price of foreign exchange also in terms of domestic currency also increase. In different word the domestic currency depreciates as the money supply increases. This paper studies the relation between money supply, price level and exchange rate in India during 2000-2010.This study finds that During the period of study  Whole Sale Price Index  ( WPI) and M1and M3 show the positive relation but WPI is more correlated with M1. In case of WPI and Nominal Exchange Rate (NER) though they should move in the same direction many a times due to global effects (US crisis of 2001, global crisis of 2008 and large capital inflows of January 2008) they did not move in the same direction. Thus negative correlation has been found between WPI and NER.