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Lesson 10-1
The Bond and Foreign Exchange Markets
Financial markets are markets where funds
accumulated by one group are made available to
another group.
The Bond Market
Bond Prices and Interest Rates
The face value of a bond is the value printed on the
bond.
The maturity date is the date on which the face
value will be paid by the issuer of the bond.
An interest rate is the payment made for the use of
money expressed as a percentage of the amount
borrowed.
As the bond price falls, the interest rate rises. As the
bond price rises, the interest rate falls.
The coupon rate is the percentage of the face value
that will be paid periodically to the holder of the bond.
If a bond does not carry a coupon rate and thus
pays only the face value when it matures, it is
called a zero-coupon bond.
Bond prices are determined by supply and
demand and can be illustrated graphically.
Supply and demand curves for bonds have
normal slopes.
The Bond Market and Macroeconomic
Performance
The price of bonds determines the interest rate.
Changes in the interest rate affect investment—higher
rates discourage the purchase of more plant and
equipment, whereas lower rates encourage such
purchases.
Since investment is a component of aggregate
demand, a change in the interest rate shifts aggregate
demand.
.
The links between bond prices and the interest rate, the
interest rate and investment, and investment and
aggregate demand can be illustrated graphically
Higher interest rates tend to reduce aggregate demand
and lower interest rates tend to increase aggregate
demand, if other factors are unchanged.
Foreign Exchange Markets
The foreign exchange market is a market in which
currencies of different countries are traded for one
another.A country’s exchange rate is the price of its
currency in terms of another currency or currencies.
Economists summarize the movement of exchange
rates with a trade-weighted exchange rate. The
trade-weighted exchange rate is an index of
exchange rates in which the exchange rate between
a country and each of its trading partners is
weighted by the amount of trade between the two
countries.
The trade-weighted exchange rate will be used
when reference is made to “the exchange rate.”
Determining Exchange Rates
Exchange rates usually are determined by supply and
demand.
The demand curve for a currency relates the number
of domestic currency units buyers want to buy in any
period to the exchange rate.
An increase in the exchange rate means that it takes
more foreign currency to buy the domestic currency. A
decrease in the exchange rate means that it takes
less foreign currency to buy the domestic currency.
A rise in the exchange rate makes foreign goods
relatively cheaper. A fall in the exchange rate makes
foreign goods relatively more expensive.
As the exchange rate rises, domestic goods appear more
expensive to foreigners. As the exchange rate falls,
domestic goods appear less expensive to foreigners.
The demand curve for any currency is expected to be
downward sloping.
The supply of foreign exchange relates the quantity of
foreign currency units to the exchange rate that domestic
residents want to buy in a period.
The supply curve for foreign exchange is usually upward
sloping.
Governments also sometimes intervene in the foreign
exchange markets, but the volume is relatively small.
Exchange Rates and Macroeconomic Performance
People purchase a country’s currency either to buy its
goods or to buy its assets—money, capital, stocks,
bonds, or real estate.
If bond prices in a country fall, the relative interest rate
in that country rises and stimulates foreign investors to
buy the country’s currency in order to buy bonds. The
exchange rate thus rises.
A higher exchange rate makes the price of domestic
goods more expensive to foreigners and thus reduces
exports while at the same time reduces the price of
foreign goods to domestic buyers and therefore
stimulates more imports. Net exports fall.