Financial Markets and the Economy

Read this chapter to build a foundation for understanding financial markets. The first section discusses the bonds and foreign exchange markets and the way they are connected through the interest rate. The second section builds the model of the money market and connects it to the other financial markets. Pay attention to how the connection is made between the financial markets and the overall economy by showing the effects on the equilibrium real GDP and the price level, using the model of aggregate demand and supply.

The Bond and Foreign Exchange Markets

Learning Objectives

  1. Explain and illustrate how the bond market works and discuss the relationship between the price of a bond and that bond's interest rate.
  2. Explain and illustrate the relationship between a change in demand for or supply of bonds and macroeconomic activity.
  3. Explain and illustrate how the foreign exchange market works and how a change in demand for a country's currency or a change in its supply affects macroeconomic activity.

In this section, we will look at the bond market and at the market for foreign exchange. Events in these markets can affect the price level and output for the entire economy.