International Finance Theory and Policy
by Steven M. Suranovic
Finance 40-12
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Integrating the Money Market and the Foreign Exchange MarketIn this section we will integrate the money market with the foreign exchange market to demonstrate the interactions that exist between the two. First, a review. In the money market the endogenous variable is the interest rate (i$). This is the variable that is determined in equilibrium in the model. The exogenous variables are the money supply (MS), the price level (P$) and the level of real GDP (Y). These variables are determined outside the money market and treated as known values. Their values determine the supply and demand for money and affect the equilibrium value of the interest rate. In the foreign exchange market (FOREX) the endogenous variable is the exchange rate, E$/£. The exogenous variables are the domestic interest rate (i$), the foreign interest rate (i£) and the expected exchange rate Ee$/£. Their values determine the domestic and foreign rates of return and affect the equilibrium value of the exchange rate. The linkage between the two markets arises because the domestic interest
rate is the endogenous variable in the money market and an exogenous variable
in the FOREX market. Thus,
when considering the FOREX, when we say the interest rate is determined
outside of the FOREX market, Linking the Diagrams We can keep track of the interactions between these two markets using a simple graphical technique. We begin with the money market diagram as developed in Section 40-7. The trick is to rotate the diagram 90° in a clockwise direction. The adjoining diagram shows the beginning of the rotation pivoted around the origin at 0.
International Finance Theory and Policy - Chapter 40-12: Last Updated on 1/11/05 |