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
- People hold money in order to buy goods and services (transactions demand), to have it available for contingencies (precautionary demand), and in order to avoid possible drops in the value of other assets such as bonds (speculative demand).
- The higher the interest rate, the lower the quantities of money demanded for transactions, for precautionary, and for speculative purposes. The lower the interest rate, the higher the quantities of money demanded for these purposes.
- The demand for money will change as a result of a change in real GDP, the price level, transfer costs, expectations, or preferences.
- We assume that the supply of money is determined by the Fed. The supply curve for money is thus a vertical line. Money market equilibrium occurs at the interest rate at which the quantity of money demanded equals the quantity of money supplied.
- All other
things unchanged, a shift in money demand or supply will lead to a
change in the equilibrium interest rate and therefore to changes in the
level of real GDP and the price level.