Bond and Foreign Exchange Markets
As you have already learned, bonds are used to finance specific projects or operations of the issuer. Through these bonds, the issuer is obligated to make payments on the bond in the future. But what determines the bond's price, and what determines the interest paid?
Along with bonds, some investors may consider investing in foreign currency. While doing so, there are a few determinants of what rate currencies will be exchanged. What are these?
Foreign Exchange Markets
Exchange Rates and Macroeconomic Performance
People purchase a country's currency for two quite different reasons: to purchase goods or services in that country, or to purchase the assets of that country - its money, its capital, its stocks, its bonds, or its real estate. Both of these motives must be considered to understand why demand and supply in the foreign exchange market may change.
One thing that can cause the price of the dollar to rise, for example, is a reduction in bond prices in American markets. Figure 25.4 "Shifts in Demand and Supply for Dollars on the Foreign Exchange Market" illustrates the effect of this change. Suppose the supply of bonds in the U.S. bond market increases from S1 to S2 in Panel (a). Bond prices will drop. Lower bond prices mean higher interest rates. Foreign financial investors, attracted by the opportunity to earn higher returns in the United States, will increase their demand for dollars on the foreign exchange market in order to purchase U.S. bonds. Panel (b) shows that the demand curve for dollars shifts from D1 to D2. Simultaneously, U.S. financial investors, attracted by the higher interest rates at home, become less likely to make financial investments abroad and thus supply fewer dollars to exchange markets. The fall in the price of U.S. bonds shifts the supply curve for dollars on the foreign exchange market from S1 to S2, and the exchange rate rises from E1 to E2.
Figure 25.4 Shifts in Demand and Supply for Dollars on the Foreign Exchange Market
In Panel (a), an increase in the supply of bonds lowers bond prices to Pb2 (and thus raises interest rates). Higher interest rates boost the demand and reduce the supply for dollars, increasing the exchange rate in Panel (b) to E2. These developments in the bond and foreign exchange markets are likely to lead to a reduction in net exports and in investment, reducing aggregate demand from AD1 to AD2 in Panel (c). The price level in the economy falls to P2, and real GDP falls from Y1 to Y2.
The higher exchange rate makes U.S. goods and services more expensive to foreigners, so it reduces exports. It makes foreign goods cheaper for U.S. buyers, so it increases imports. Net exports thus fall, reducing aggregate demand. Panel (c) shows that output falls from Y1 to Y2; the price level falls from P1 to P2. This development in the foreign exchange market reinforces the impact of higher interest rates we observed in Figure 25.2 "Bond Prices and Macroeconomic Activity", Panels (c) and (d). They not only reduce investment - they reduce net exports as well.