Exchange Rate Endogenous or Exogenous

Hi,

This is a good question because knowing what is exogenous and what is endogenous is pretty important!

Let's start with our simple goods market equation (the IS curve):

Y = C(Y) + I(i,Y) + G + NX(e,Y)

If we just have this 1 equation then we can only endogenously solve for 1 variable. In this model, we are interested in determining output, Y. This means that both i and e are *exogenous*.

But, you want a model that can explain interest rate movements --- we want to endogenize the interest rate. To do this we need another equation. Well, that equation is the LM curve.

We now have two equations (IS and LM) and have two endogenous variables --- Y and i (e is still exogenous).

But, you want a model that can explain exchange rate movements --- we want to endogenize the exchange rate. To do this we need yet another equation. The equation that we need is UIP.

Now we have three equations (IS,LM,UIP) and our model can explain the movement of 3 (endogenous) variables: Y,i,e

Best
Oliver

I think in fixed exchange rate instead of e being endogenous Money Supply becomes endogenous... as the Central Bank has to adjust the money supply to maintain an exogenously determined Exchange rate (e) (as determined by whatever country they are fixing it to. I think?