Foreign Exchange Market Equilibrium:

We say that the foreign exchange market is in equilibrium when deposits of all currencies oer the same expected rate of return (when returns are denominated in the same currency). Formally,

a Explain why in Figure 1 the foreign exchange market is not in equilibrium at points 2 and 3. Do not forget to use a graph to support your answer and describe how the equilibrium can be restored. Note that in this problem the U.S. is the domestic economy and Europe is the foreign economy. b Now suppose the foreign exchange market is in equilibrium (i.e. point 1 in Figure 1). Explain what would happen to the USD/euro nominal exchange rate if the interest rate in Europe falls. Do not forget to use a graph to support your answer.