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.
Demand, Supply, and Equilibrium in the Money Market
- Explain the motives for holding money and relate them to the interest rate that could be earned from holding alternative assets, such as bonds.
- Draw a money demand curve and explain how changes in other variables may lead to shifts in the money demand curve.
- Illustrate and explain the notion of equilibrium in the money market.
- Use graphs to explain how changes in money demand or money supply are
related to changes in the bond market, in interest rates, in aggregate
demand, and in real GDP and the price level.
In this section we
will explore the link between money markets, bond markets, and interest
rates. We first look at the demand for money. The demand curve for money
is derived like any other demand curve, by examining the relationship
between the "price" of money (which, we will see, is the interest rate)
and the quantity demanded, holding all other determinants unchanged. We
then link the demand for money to the concept of money supply developed
in the last chapter, to determine the equilibrium rate of interest. In
turn, we show how changes in interest rates affect the macroeconomy.