Question

How would I show graphically how the exchange rate would move to bring the market into equilibrium if the interest parity does not hold.

Answer 1

In the above graph since there is no influence of interest parity. The exchange rate market would be simply influenced by increase or decrease in tastes and preferences for foreign goods. The graph A shows an increase in demand for foreign goods indicated by a rightward shift in demand curve and appreciation of the foreign currency at R2 which is at equilibrium at E2 at quantity level Q2 (increase in quantity demanded and supplied of Q2)

In graph B The value of the foreign currency depreciates and the domestic currency appreciates. As a result of which the new equilibrium is at E1 and foreign currency rate falls to R1 and the supply of the foreign currency increases at Q1 level. This may be because of the increased preference for the goods of the home country by the foreign country or increase in national income of the foreign country.