Interest Rate Determination
Here, you will learn about determining interest rates and how supply and demand play a role in determining interest rates. Pay attention to the Fed's role in this determination and to the effects of the increase of money supply on interest rates. What are the determinants of interest rates?
Integrating the Money Market and the Foreign Exchange Markets
Learning Objective
- Integrate the money market with the foreign exchange market and highlight the interactions that exist between the two.
In this section, we will integrate the money market with the foreign exchange market to demonstrate the interactions that exist between the two. First, let's 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 gross domestic product (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 (Forex) market, 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 (E$/£e). 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, we know where it is determined: it is determined in the U.S. money market as the interest rate that satisfies real supply and demand for money.