Money and FX Markets

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Moneyand FX Markets

Moneyand FX Markets

Globalizationhas resulted in the growth of international trade. This has, in turn,necessitated research into different models for exchange ratedetermination to support the trade given the different globalcurrencies. These exchange rate determination models combine severaleconomic statistics of the individual economies to determine thefuture rates of return on their currency deposits and therefore theirrespective exchange rates. The exchange rate is the number of timesone currency can buy or be bought by another in the foreign exchangemarket. The models of exchange rate determination employ severaleconomic money market parameters in the process of developingequilibrium in the foreign exchange market. This paper is anexplanation of the functioning of the exchange rate determinationmodel in chapter 15 of the book.

‘Chapter15’ Exchange Rate Determination Model

Thismodel has employed the following economic parameters in the twomarkets – the quantity of money in the economy, the domestic interestrates and exchange rates. The model is a combination of twoequilibriums where the one in the domestic money market determinesthe equilibrium in the foreign exchange market. The lower part of themodel contains the domestic money market rotated at 90 degrees(Krugman, Obstfeld &amp Melitz, 2012). This is so as to make itsy-axis – the interest rate to fit with the foreign exchangemarket`s ‘currency rate of return.` This forms the x-axis for themodel as seen on ‘figure 15 – 6’. The model can be explainedseparately to show the movements in the different markets that resultin the two equilibriums and by extension determine the expectedexchange rates.

TheDomestic Money market

Themoney supply in the domestic money markets is almost fixed in theshort-run and is determined by the individual countries’ centralbanks. The interest rate in this market is determined afterequilibrium is created by the point of intersection of the moneydemanded curve and the money supply – ‘M/P curve’ as seen on‘figure 15 – 4’. Changes in the money supplied in the economyleads to a shift of the ‘M/P curve’ – with an increase leadingto a shift of the curve to the right and vice versa. Similarly, anincrease in the real income in the economy leads to a shift in the‘L(R, Y) curve,’ to the right. Such movements in the economyresult in disequilibrium in the market, and a new equilibrium iscreated by the new points of intersection. This new equilibriumdetermines the matching interest rate (James, Marsh &amp Sarno,2012).

ForeignExchange Market

Inthe model, the new interest rate established in the domestic moneymarket forms the dollar-value for the other currency deposits in theforeign market. In ‘figure 15 – 6,’ for example, the interestrate calculated in the US market is the rate of return for Eurodeposits. Depreciation or appreciation of the value of foreigndeposits is expected based on this new rate, which then results in anew equilibrium being established (Krugman, Obstfeld &amp Melitz,2012). The equilibrium is represented by the point where expectedrate of return on the foreign currency is equal to the rate of returndetermined in the money market, which extends upwards into theforeign market graph. This intersection point determines the expectedexchange rate for the foreign currency against the domestic currency,on the y-axis of the model in ‘chapter 15’.

Effectof Changes in Money Supply on the Two Market Equilibriums

Moneysupply in the domestic market is determined by the central banks. Anexample is during an economic depression, where the Central Bankraises money supply through a combination of fiscal and monetarypolicies to counter the effects. An increase in money supply willresult in the ‘M/P curve’ to shift to the right on the moneymarket graph (James, Marsh &amp Sarno, 2012). To re-establishequilibrium, the market will move along the downward sloping moneydemand curve to the right to create a new intersection with the new‘M/P curve as point 2’ in the graph. This movement is caused bythe excess supply situation that has resulted in the money market dueto the increase in real money in the economy.

Lowerinterest rates in the domestic market will result in the expectedreturns from the foreign currency deposits to be greater than that ofthe domestic currency. This will make the holders of the domesticcurrency in the foreign exchange market to sell off and bid for theforeign currency instead. Selling off the domestic currency in theforeign exchange market will create excess supply. This coupled withthe increasing demand and bids for the foreign currency willdepreciate the domestic currency in the foreign exchange market(Krugman, Obstfeld &amp Melitz, 2012). A new equilibrium isestablished at the intersection between the new interest rate and therate of the return of the foreign currency. This higher equilibriummakes the foreign currency to become stronger, represented by itshigher exchange rate in the market.


Anaccurate exchange rate determination model helps players ininternational trade to avoid foreign exchange risks. Countries alsoaim to maintain the values of their currencies in the market forcompetitive reasons and also to sustain the values of their depositsin the foreign exchange market. The model in ‘chapter 15’ of thebook uses the relevant economic parameters to determine the value ofone currency against another in the foreign currency market.


James,J., Marsh, I. W., &amp Sarno, L. (2012). Handbookof exchange rates.Hoboken, New Jersey: John Wiley &amp Sons, Inc.

Krugman,P. R., Obstfeld, M., &amp Melitz, M. J. (2012). Internationaleconomics: Theory &amp policy.Boston: Pearson Addison-Wesley.