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12 Integrating the Money Market and the Foreign Exchange Markets

# 12 Integrating the Money Market and the Foreign Exchange Markets

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outside of the Forex market, we know

Figure 7.7 Ninety-Degree Rotation of the Money

where it is determined: it is determined in

Market Diagram

the U.S. money market as the interest rate
that satisfies real supply and demand for
money.

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
Figure 7.8 Money-Forex Diagram

inChapter 7 "Interest Rate
Determination", Section 7.7 "Money Functions
and Equilibrium". The trick is to rotate the
diagram ninety degrees in a clockwise
direction.Figure 7.6 "Rotating the Money
Market Diagram" shows the beginning of the
rotation pivoted around the origin at zero.
When rotated the full ninety degrees, it will be
positioned as shown in Figure 7.7 "NinetyDegree Rotation of the Money Market
Diagram". The most important thing to
value of real money supply and demand
increases downward away from the origin at
zero along the vertical axis. Thus when the
money supply “increases,” this will be

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represented in the diagram as a “downward” shift in the real money supply line. The interest rate, in
contrast, increases away from the origin to the right along the horizontal axis when rotated in this
position.
Since the interest rate is identical to the rate of return on dollar assets from a U.S. dollar holder’s
perspective (i.e., RoR\$ = i\$), we can now place the RoR diagram directly on top of the rotated money
market diagram as shown in Figure 7.8 "Money-Forex Diagram". The equilibrium interest rate (i′\$), shown
along the horizontal axis above the rotated money market diagram, determines the position of
the RoR\$ line in the Forex market above. This combined with the RoR£ curve determines the equilibrium
exchange rate, E′\$/£, in the Forex market. We will call this diagram the “money-Forex diagram” and the
combined model the “money-Forex model.”

KEY TAKEAWAY

Using a two-quadrant diagram with appropriate adjustments, we can represent the equilibrium
in the money market and the foreign exchange market simultaneously.

EXERCISE

1. Jeopardy Questions. As in the popular television game show, you are given an answer to
a question and you must respond with the question. For example, if the answer is “a tax
on imports,” then the correct question is “What is a tariff?”
a.

The value of this endogenous variable is used to determine the position of the U.S. rate

of return line.
b. In the money-Forex diagram, these are the two endogenous variables.
c. In the money-Forex diagram, these are the five exogenous variables.

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7.13 Comparative Statics in the Combined Money-Forex Model
LEARNING OBJECTIVE

1.

Show the effects of an increase in the money supply and an increase in GDP on the interest rate
and exchange rate using the two-quadrant money-Forex market diagram.

Comparative statics is any exercise examining how the endogenous variables will be affected when one of
the exogenous variables is presumed to change, while holding all other exogenous variables constant.
Holding other variables constant at their original values is the “ceteris paribus” assumption. We will do
several such exercises here using the combined money-Forex market diagram.

An Increase in the U.S. Money Supply
Figure 7.9 Effects of an Increase in the
Money Supply

Suppose the U.S. money supply increases, ceteris
paribus. The increase in MS causes an increase in the
real money supply (MS/P\$), which causes the real
money supply line to shift “down”
from MS′/P\$ to MS″/P\$ (step 1) in the adjacent MoneyForex diagram, Figure 7.9 "Effects of an Increase in the
Money Supply". (Be careful here: down in the diagram
means an increase in the real money supply.) This
causes a decrease in the equilibrium interest rate
from i\$′ to i\$″ (step 2). The decrease in the U.S. interest
rate causes a decrease in the rate of return on dollar
assets: RoR\$ shifts from RoR\$′ to RoR\$″ (step 3).
Finally, the reduction in the dollar rate of return
causes an increase in the exchange rate
from E′\$/£ to E″\$/£ (step 4). This exchange rate change
corresponds to an appreciation of the British pound
and a depreciation of the U.S. dollar. In summary, an
increase in the U.S. money supply, ceteris paribus,
causes a decrease in U.S. interest rates and a

depreciation of the dollar.
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An Increase in U.S. GDP
Suppose there is an increase in U.S. GDP, ceteris

Figure 7.10 Effects of an Increase in GDP

paribus. This will increase real money demand,
causing a “downward” shift in the real money
demand curve fromL(i\$, Y\$′) to L(i\$, Y\$″) (step 1) in

the

Money-Forex diagram, Figure 7.10 "Effects of an
Increase in GDP". (Remember, real money
increases as you move down on the rotated money
diagram.) This causes an increase in the U.S.
interest rate from i\$′ to i\$″ (step 2). The increase in

the

interest means that the rate of return on dollar

assets

increases from RoR\$′ to RoR\$″ (step 3). Finally, the
increase in the U.S. RoR causes a decrease in the
exchange rate from E′\$/£ to E″\$/£ (step 4). The
exchange rate change corresponds to an
appreciation of the U.S. dollar and a depreciation

of the

British pound. In summary, an increase in real

U.S.

GDP, ceteris paribus, causes an increase in U.S.
interest rates and appreciation (depreciation) of the U.S. dollar (British pound).

KEY TAKEAWAYS

In the money-Forex model, an increase in the U.S. money supply, ceteris paribus, causes a
decrease in U.S. interest rates and a depreciation of the dollar.

In the money-Forex model, an increase in real U.S. gross domestic product (GDP), ceteris paribus,
causes an increase in U.S. interest rates and appreciation (depreciation) of the U.S. dollar (British
pound).

EXERCISE

1. Using the Forex market and money market models, indicate the effect of each change
listed in the first row of the table, sequentially, on the variables listed in the first column.
For example, “Expansionary U.S. Monetary Policy” will first cause an increase in the “Real
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