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_$ = R_E+ (E^e_$/E - E_$/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.

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.