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macro in a nutshell
The FE-curve

The FE curveThe FE curve identifies combinations of income and the interest rate for which the foreign exchange market is in equlibrium.

In today's world with integrated international capital markets the FE curve is horizontal. The reason is that if financial investors saw higher interest rates (or returns) abroad than at home, they would shift huge amounts of wealth out of the home country into the remaining world capital market. An excess demand for foreign currencies would result, and the foreign exchange market could not possibly be in equlibrium. To prevent this, the yields of financial investments at home must be the same as the yields of financial investments abroad. This is only the case if the domestic interest rate exactly equals the world interest rate (assuming financial investors do not expect exchange rates to change). Therefore, in an interest rate/income diagram the FE curve is a horizontal line at the world interest rate. This means that no matter how high domestic income is, the domestic interest rate must always equal the world interest rate to keep the foreign exchange market in equilibrium.

Further reading on pp. 90ff.
Click here for interactive applet featuring the foreign exchange market and motivating the horizontal FE-curve



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