The monetary model links the foreign exchange market (PPP 13.2) with the domestic macro-economy (money demand equation 13.1). The graph below illustrates both markets. The button on the left shows the equilibrium. The one on the right gives you an illustration of the foreign exchange market.
We depict the foreign exchange market in the S-P diagram. Therein, the purchasing power parity is a straight line of origin that divides the quadrant into two parts. In the lower half, the domestic economy is over-competitive, i.e. goods from the domestic market are sold cheaper on the international market than goods from abroad. This can easily be illustrated with the help of test point T. If we are in a situation with T in the area below the PPP line, then (1) the domestic price level is lower than the price level which would correspond to the PPP at this exchange rate, or vice versa (2) the exchange rate is stronger devalued than the exchange rate which would correspond to the PPP at this price level, or (3) a combination of both. Domestic goods are cheaper than goods from abroad. Domestic exports are booming, imports are low and the foreign trade balance is positive.
Above the PPP-line, the situation is the opposite. The domestic economy has competitive disadvantages and is under-competitive. If T is above the PPP-line, then (1) the domestic price level is higher than the price level , which at this exchange rate would correspond to the PPP, or vice versa (2) the exchange rate is more strongly appreciated than the exchange rate which at this price level would correspond to the PPP, or (3) a combination of both. Domestic goods are more expensive than goods from abroad. Domestic exports are low, imports are high and the foreign trade balance is negative.
With the left button you can display the equilibrium. We start on the domestic market. The money market equilibrium () defines the money demand curve in the diagram. For a given economic output (vertical line), the curve shows a corresponding price level If this is transferred to the foreign exchange market (dashed line), the equilibrium exchange rate is the point of intersection with the PPP line. The equilibrium is an attractor and self-stabilising. If, for example, the exchange rate is too high (overvaluation of the domestic currency the value of is too low) for the given price level, then exports would subside and the foreign trade balance would be negative. This would result in an increased demand for foreign exchange and an oversupply of domestic currency, which would push the exchange rate price of one’s own currency against the foreign currency) down again. The overvaluation would be reduced.