Combine the Money Market with the Foreign Exchange Market
Combining the money market and the foreign exchange market in the Monetary Approach to Balance of Payment (MBOP) makes it possible to relate the change in the money market of one of the countries to the changes in the exchange rate.
The combined MBOP
The MBOP model combines two models: the money market and the foreign exchange market.
The combination of the money market and the foreign exchange market is possible because the y-axis of the U.S. money market (the real interest rate in the U.S.) is the same as the x-axis of the foreign exchange market (the real return on the dollar-denominated security).
Note that the U.S. money market is rotated to take advantage of the common axes in separate models. Also note that the figure explicitly shows the U.S. money market. The Euro-zone’s money market is implied by the parity curve in the foreign exchange model (r€E).
The figure also makes it clear that, according to the MBOP, the exchange rate observed in the foreign exchange market has to be consistent with the money market equilibrium in both the U.S. and Euro-zone money markets.
In other words, the current exchange rate observed on the y-axis of the foreign exchange market is determined based on the real return on the dollar- and euro-denominated securities. Of course, the real return on the euro-denominated security is transformed into the expected real return on the euro-denominated security in dollars so that the real returns on these two different securities are comparable.
Changes in the exchange rate equilibrium in the combined MBOP
The variables that affect the current exchange rate remain the same. The only difference is that you can see the U.S. money market explicitly, and the Euro-zone’s money market is implied by the parity curve in the foreign exchange market.
Therefore, shocks to output or nominal money supply (the latter has an effect only in the short run) either in the U.S. or the Euro-zone money market change the way investors compare dollar- and euro-denominated securities.