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macro in a nutshell
FE and the price level

3D FE planeThe FE curve says that the foreign exchange market may be in equilibrium if and only if the domestic interest rate equals the world interest rate. Only then financial investors are indifferent as to where (at home or abroad) they hold their assets. Does this change if, say, the domestic price level doubles? Obviously not: Financial investors still hunt for the highest interest rate, and equilibrium may only obtain if international interest rates are equal. This means that if we generalize the FE curve into an FE plane in a diagram that adds the price level as a third dimension to our previous i/Y diagram, the result is a horizontal FE plane at the level of the world interest rate.


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