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.
Summary
We
began this chapter by looking at bond and foreign exchange markets and
showing how each is related to the level of real GDP and the price
level. Bonds represent the obligation of the seller to repay the buyer
the face value by the maturity date; their interest rate is determined
by the demand and supply for bonds. An increase in bond prices means a
drop in interest rates. A reduction in bond prices means interest rates
have risen. The price of the dollar is determined in foreign exchange
markets by the demand and supply for dollars.
We then saw how the
money market works. The quantity of money demanded varies negatively
with the interest rate. Factors that cause the demand curve for money to
shift include changes in real GDP, the price level, expectations, the
cost of transferring funds between money and nonmoney accounts, and
preferences, especially preferences concerning risk. Equilibrium in the
market for money is achieved at the interest rate at which the quantity
of money demanded equals the quantity of money supplied. We assumed that
the supply of money is determined by the Fed. An increase in money
demand raises the equilibrium interest rate, and a decrease in money
demand lowers the equilibrium interest rate. An increase in the money
supply lowers the equilibrium interest rate; a reduction in the money
supply raises the equilibrium interest rate.