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
- A bond represents a borrower's debt; bond prices are determined by demand and supply.
- The interest rate on a bond is negatively related to the price of the bond. As the price of a bond increases, the interest rate falls.
- An increase in the interest rate tends to decrease the quantity of investment demanded and, hence, to decrease aggregate demand. A decrease in the interest rate increases the quantity of investment demanded and aggregate demand.
- The demand for dollars on foreign exchange markets represents foreign demand for U.S. goods, services, and assets. The supply of dollars on foreign exchange markets represents U.S. demand for foreign goods, services, and assets. The demand for and the supply of dollars determine the exchange rate.
- A rise in U.S. interest
rates will increase the demand for dollars and decrease the supply of
dollars on foreign exchange markets. As a result, the exchange rate will
increase and aggregate demand will decrease. A fall in U.S. interest
rates will have the opposite effect.