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?
Answer to Try It! Problem
If the supply of bonds decreases from S1 to S2, bond prices will rise from Pb1 to Pb2, as shown in Panel (a). Higher bond prices mean lower interest rates. Lower interest rates in the United States will make financial investments in the United States less attractive to foreigners. As a result, their demand for dollars will decrease from D1 to D2, as shown in Panel (b). Similarly, U.S. financial investors will look abroad for higher returns and thus supply more dollars to foreign exchange markets, shifting the supply curve from S1 to S2. Thus, the exchange rate will decrease. The quantity of investment rises due to the lower interest rates. Net exports rise because the lower exchange rate makes U.S. goods and services more attractive to foreigners, thus increasing exports, and makes foreign goods less attractive to U.S. buyers, thus reducing imports. Increases in investment and net exports imply a rightward shift in the aggregate demand curve from AD1 to AD2. Real GDP and the price level increase.
