## Output the Exchange Rate and Asset Market Equilibrium

In Chapter 13 we studied the interest parity condition, which states that the foreign exchange market is in equilibrium only when the expected rates of return on domestic and foreign currency deposits are equal. In Chapter 14 we learned how the interest rates that enter the interest parity relationship are determined by the equality of real money supply and real money demand in national money markets. Now we combine these asset market equilibrium conditions to see how the exchange rate and output must be related when all asset markets simultaneously clear. Because the focus for now is on the domestic economy, the foreign interest rate is taken as given.

For a given expected future exchange rate, the interest parity condition describing foreign exchange market equilibrium is equation (13-2),

R = R* + (Ee - E)!E, where R is the interest rate on domestic currency deposits and R* is the interest rate on foreign currency deposits. In Chapter 14 we saw that the domestic interest rate satisfying the interest parity condition must also equate the real domestic money supply (A1xiP) to aggregate real money demand (see equation (14-4)):

You will recall that aggregate real money demand L(R, K) rises when the interest rate falls because a fall in R makes interest-bearing nonmoney assets less attractive to hold. (Conversely, a rise in the interest rate lowers real money demand.) A rise in real output, Y, increases real money demand by raising the volume of monetary transactions people must carry out (and a fall in real output reduces real money demand by reducing transactions needs).

We now use the diagrammatic tools developed in Chapter 14 to study the changes in the exchange rate that must accompany output changes so that asset markets remain in equilibrium. Figure 16-6 shows the equilibrium domestic interest rate and exchange rate associated with the output level K1 for a given nominal money supply, M\ a given domestic price level, P, a given foreign interest rate, /?*, and a given value of the expected future exchange rate, E'\ In the lower part of the figure, we see that with real output at K1 and the real money supply at MSIP, the interest rate /?' clears the home money market (point 1) while the exchange rate E] clears the foreign exchange market (point J'). The exchange rate Ex clears the foreign exchange market because it equates the expected rate of return on foreign deposits, measured in terms of domestic currency, to /?'.

A rise in output from Y] to Y2 raises aggregate real money demand from L(R, K1) to L{R, Y2), shifting out the entire money demand schedule in the lower part of Figure 16-6. This shift, in turn, raises the equilibrium domestic interest rate to R2 (point 2). With E" and R* fixed, the domestic currency must appreciate from E] to E2 to bring the foreign exchange market back into equilibrium at point 2'. The domestic currency appreciates by just enough that the increase in the rate at which it is expected to depreciate in the future offsets the increased interest rate advantage of home currency deposits. For asset markets to remain in equilibrium, a rise in domestic output must be accompanied by an appreciation of the domestic currency, all else equal, and a fall in domestic output must be accompanied by a depreciation.