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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.
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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
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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.
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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
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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
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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
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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.
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Determining an Exchange
Rate
Exchange rate
S
E
D
Q
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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
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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.
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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.
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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.
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2.1 The Demand for Money
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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
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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
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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.
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2.3 Equilibrium in the Market
for Money
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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’
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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
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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
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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
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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
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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
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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
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Money Market
Equilibrium
27
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How Money Supply Changes
affect GDP
28
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Money Supply vs. Interest Rates
Interest
Rates
Interest
Rates
Fall
M1
M2
Fed Increases
Money Supply
r1
r2
Md
Money
29
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