Discuss the foreign exchange market equilibrium, Electrical Engineering

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Q. To answer the following question, please refer to the figure below. Concentrating only at the upper right quadrant, discuss the foreign exchange market equilibrium.

Answer: The upper right quadrant illustrates the balance in the foreign exchange market.

We start with an Interest Parity Condition:

R$ = RE+ (Ee$/E - E$/E) / E$/E.

Generally two effects are present:

R1$ moves to R2$ and E1$/E shifts to E2$/E.

An increase in the interest rate usually creates an excess demand for dollar deposits and appreciation in the currency market.

1010_Discuss the foreign exchange market equilibrium.png

Though in this case the increase is because of higher expected inflation or higher expected financial growth in the U.S which implies a faster predictable depreciation of the dollar against the euro E thus Ee$E goes up and thus reduces the attractiveness of U.S deposits.


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