The
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.
