FE curve identifies combinations of income and the interest rate
for which the foreign exchange market is in equlibrium.
Further reading on pp. 90ff.
In today's world with integrated international capital markets the
FE curve is horizontal. The reason is that if financial investors
saw higher interest rates (or returns) abroad than at home, they
would shift huge amounts of wealth out of the home country into
the remaining world capital market. An excess demand for foreign
currencies would result, and the foreign exchange market could not
possibly be in equlibrium. To prevent this, the yields of financial
investments at home must be the same as the yields of financial
investments abroad. This is only the case if the domestic interest
rate exactly equals the world interest rate (assuming financial
investors do not expect exchange rates to change). Therefore, in
an interest rate/income diagram the FE curve is a horizontal line
at the world interest rate. This means that no matter how high domestic
income is, the domestic interest rate must always equal the world
interest rate to keep the foreign exchange market in equilibrium.
Click here for interactive applet featuring the foreign exchange market and motivating the horizontal FE-curve