Interest Rate Determination

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 Chapter 18 "Interest Rate Determination", Section 18.7 "Money Functions and Equilibrium". The trick is to rotate the diagram ninety degrees in a clockwise direction. Figure 18.6 "Rotating the Money Market Diagram" shows the beginning of the rotation pivoted around the origin at zero.

Figure 18.6 Rotating the Money Market Diagram

When rotated the full ninety degrees, it will be positioned as shown in Figure 18.7 "Ninety-Degree Rotation of the Money Market Diagram". The most important thing to remember about this new diagram is that the 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 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.

Figure 18.7 Ninety-Degree Rotation of the Money Market Diagram

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_$), we can now place the RoR diagram directly on top of the rotated money market diagram as shown in Figure 18.8 "Money-Forex Diagram". The equilibrium interest rate (i′_$), 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".