Question

Why is it that in a pure, flexible exchange rate system, the foreign exchange market has no direct effect on the money supply? Does this mean that the foreign exchange market has no effect on monetary policy?

Short answer

Floating or fixed rate of exchange system is that rate system within which rate of exchange of a currency is set by the economic process (market demand and market supply of that currency). there's no intervention by the central government to regulate the cash supply or demand within the floating rate system. When government intervenes within the market to manage the cash supply in flexible rate system, it's called dirty floating.

Step-by-step solution

Concept Introduction

Exchange market refers to the market where the exchange of currencies takes place. it's an area where one can trade for the currencies and thru which the provision and demand of a currency is decided which determines the interchange rate of that currency.

Explanation of Solution

In flexible rate system, the exchange market has no effect on monetary policy as there's no government intervention in flexible rate. The exchnage rate is determined through the movement of demand and supply of currencies.

But an indirect effect may exist as the central bank might attempt to influence exchange rates through interest rates and money supply.