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© 2013, published by Flat World Knowledge Published by: Flat World Knowledge, Inc. One Bridge Street Irvington, NY 10533 © 2013 by Flat World Knowledge, Inc. All rights reserved. Your use of this work is subject to the License Agreement available here http://www.flatworldknowledge.com/legal. No part of this work may be used, modified, or reproduced in any form or by any means except as expressly permitted under the License Agreement. © 2013, published by Flat World Knowledge 1. THE BOND AND FOREIGN EXCHANGE MARKETS Financial markets are markets in which funds accumulated by one group are made available to another group. – Savers supply funds to financial markets and borrowers demand funds. © 2013, published by Flat World Knowledge 1. 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 © 2013, published by Flat World Knowledge macroeconomic activity. 1.1 The Bond Market • • • • Bond prices and interest rates. The face value of a bond is the amount the issuer of a bond will have to pay on the maturity date. The maturity date is the date when a bond matures, or comes due. The interest rate is the payment made for the use of money, expressed as a percentage of the amount borrowed. © 2013, published by Flat World Knowledge 1.1 The Bond Market EQUATION 1.1 • Face value bond price 100 inte ra Bond price At a price of $950, the interest rate is 5.3% $1,000 $950 100 5 . 3 % $950 © 2013, published by Flat World Knowledge 1.1 The Bond Market S1 S2 An increase in borrowing increases supply of bonds $950 (r=5.3%) $900 (r=11.1%) D1 Q1 Q2 © 2013, published by Flat World Knowledge Bond Prices and Macroeconomic Activity S1 SRAS1 P2b P1b real GDP and the price level rise. P2 D2 P1 D1 Q1 AD1 Q2 AD2 Y1 Y2 When bond prices go up… S1 S2 P1b P2b SRAS1 real GDP and the price level may fall. P1 P2 D1 When bond prices fall… Q1 Q2 © 2013, published by Flat World Knowledge AD2 Y2 Y1 AD1 1.2 Foreign Exchange Markets • • • • • A foreign exchange market is a market win which currencies of different countries are traded for one another. The exchange rate. A trade weighted exchange rate is an index of exchange rates. Determining exchange rates. Exchange rates and macroeconomic performance. © 2013, published by Flat World Knowledge Determining an Exchange Rate Exchange rate S E D Q © 2013, published by Flat World Knowledge Shifts in Demand and Supply for Dollars on the Foreign Exchange Market S2 S1 S1 SRAS S2 E2 P1 P1b P2 E1 P2b D1 D1 Q1 Q2 An increase in the supply of bonds lowers bond prices and raises interest rates. Q1 Q2 D2 AD2 Y2 AD1 Y1 Higher interest rates These changes lead to a boost demand and reduce reduction in net exports and supply of dollars, Investments, reducing AD. increasing the exchange © 2013, published by Flat World Knowledge rate. 2. DEMAND, SUPPLY, AND EQUILIBRIUM IN THE MONEY MARKET Learning Objectives 1. Explain the motives for holding money and relate them to the interest rate that could be earned from holding alternative assets, such as bonds. 2. Draw a money demand curve and explain how changes in other variables may lead to shifts in the money demand curve. 3. Illustrate and explain the notion of equilibrium in the money market. 4. 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. © 2013, published by Flat World Knowledge 2.1 The Demand for Money • • • • Demand for money is the relationship between the quantity of money people want to hold and the factors that determine that quantity. Motives for holding money Transactions demand for money refers to money people hold to pay for goods and services they anticipate buying. Precautionary demand for money is the money people hold for contingencies. © 2013, published by Flat World Knowledge 2.1 The Demand for Money • • • Speculative demand for money is the money held in response to concern that bond prices and the prices of other financial assets might change. Interest rates and the demand for money. The demand curve for money is a curve that shows the quantity of money demanded at each interest rate, all other things unchanged. © 2013, published by Flat World Knowledge 2.1 The Demand for Money © 2013, published by Flat World Knowledge 2.1 The Demand for Money An increase in real GDP, for example, causes demand to increase. At the same interest rate the quantity of money demanded increases from M to M’. • Other determinants of the demand for money – Real GDP – The Price Level – Expectations – Transfer Costs – Preferences © 2013, published by Flat World Knowledge 2.2 The Supply of Money • Supply curve of money is the curve that shows the relationship between the quantity of money supplied and the market interest rate all other determinants of supply unchanged. M © 2013, published by Flat World Knowledge 2.3 Equilibrium in the Market for Money • • Money market is the interaction among institutions through which money is supplied to individuals, firms, and other institutions that demand money. Money market equilibrium is the interest rate at which the quantity of money demanded is equal to the quantity of money supplied. © 2013, published by Flat World Knowledge 2.3 Equilibrium in the Market for Money © 2013, published by Flat World Knowledge 2.4 Effects of Changes in the Money Market • An decrease in the demand for money S1 r1 r2 D1 P1 D2 D1 Q1 M • P2 P1b D2 SRAS S1 P2b AD2 AD1 Q2 Y1 Y2 An increase in the supply of money after the Fed buys bonds S1 S2 r1 SRAS S1 P2b r2 P1b P2 P1 D1 Q1 D1 D2 Q2 M M’ © 2013, published by Flat World Knowledge AD2 AD1 Y1 Y2 Open Market Operations Open Market Operations (OMOs): the buying and selling of government bonds by the Fed to control bank reserves, the federal funds rate, and the money supply. For example, if the FOMC wants to increase the money supply, it gives a directive to the trading desk at the FRB-NY to buy bonds. When the FRB-NY buys bonds, it writes checks on itself, injecting new reserves into the banks of the bond sellers. The increase in reserves result in an increase in the money supply and a reduction in the fed funds rate. 21 Copyright © Houghton Mifflin Company. All rights reserved. Foreign Exchange Market Intervention Foreign exchange market intervention: the buying and selling of currencies by a central bank to achieve a specified exchange rate. Coordinated interventions involve two or more central banks working together in attempts to shift an equilibrium exchange rate. To prevent unwanted domestic money supply changes resulting from intervention, the Fed may attempt to offset the domestic effect by combining domestic OMOs with intervention. This is called sterilization. 22 Copyright © Houghton Mifflin Company. All rights reserved. Money Demand: Demand for LIQUID forms of wealth Why do people want to hold money? – – – Transactions demand: people want to hold money so that they can buy goods and services. Precautionary demand: people may demand money to cover unplanned transactions or emergencies. Speculative demand: people may want to hold money as a way to deal with uncertainty about the value of other assets. (They are afraid of declines in the values of other assets, so hold money as a safeguard.) 23 Copyright © Houghton Mifflin Company. All rights reserved. Money Demand Money demand is a negative function of the rate of interest. The interest rate is the opportunity cost of holding money. Those who hold money must forgo receiving interest. The higher the interest rate the lower the quantity of money demanded. 24 Copyright © Houghton Mifflin Company. All rights reserved. The effect of a change in income on money demand Transactions demand increases with income. As nominal income increases, the volume of transactions increase, requiring additional demand for money. 25 Copyright © Houghton Mifflin Company. All rights reserved. Money Supply The money supply is controlled by the Fed, and therefore is not a function of interest rates. As a result the money supply function is vertical. 26 Copyright © Houghton Mifflin Company. All rights reserved. Money Market Equilibrium 27 Copyright © Houghton Mifflin Company. All rights reserved. How Money Supply Changes affect GDP 28 Copyright © Houghton Mifflin Company. All rights reserved. Money Supply vs. Interest Rates Interest Rates Interest Rates Fall M1 M2 Fed Increases Money Supply r1 r2 Md Money 29 Copyright © Houghton Mifflin Company. All rights reserved.