1. Chapter 10 Financial Markets and the Economy

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3. 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.

4. 1. THE BOND AND FOREIGN EXCHANGE MARKETS
Learning Objectives
Explain and illustrate how the bond market works and discuss the relationship between the price of a bond and that bond’s interest rate.
Explain and illustrate the relationship between a change in demand for or supply of bonds and macroeconomic activity.
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 macroeconomic activity.

5. 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.

6. 1.1 The Bond Market EQUATION 1.1
At a price of $950, the interest rate is 5.3%

7. An increase in borrowing increases supply of bonds
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

8. Bond Prices and Macroeconomic Activity
SRAS1
P2b
real GDP and the price level rise.
P1b P2 D2 P1 D1
AD1
AD2 Q1 Q2 Y1 Y2
When bond prices go up… S1 S2
SRAS1
real GDP and the price level may fall.
P1b P1
P2b P2 D1
AD2
AD1
When bond prices fall… Q1 Q2 Y2 Y1

9. 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.

10. Determining an Exchange RateS E D Q

11. Shifts in Demand and Supply for Dollars on the Foreign Exchange Market
SRAS E2 P1
P1b P2 E1
P2b D1 D1 D2
AD2
AD1 Q1 Q2 Q1 Q2 Y2 Y1
An increase in the supply of bonds lowers bond prices and raises interest rates.
Higher interest rates boost demand and reduce supply of dollars, increasing the exchange rate.
These changes lead to a reduction in net exports and Investments, reducing AD.

12. 2. DEMAND, SUPPLY, AND EQUILIBRIUM IN THE MONEY MARKET
Learning Objectives
Explain the motives for holding money and relate them to the interest rate that could be earned from holding alternative assets, such as bonds.
Draw a money demand curve and explain how changes in other variables may lead to shifts in the money demand curve.
Illustrate and explain the notion of equilibrium in the money market.
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.

13. 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.

14. 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.

15. 2.1 The Demand for Money

16. 2.1 The Demand for Money Other determinants of 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

17. 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

18. 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.

19. 2.3 Equilibrium in the Market for Money

20. 2.4 Effects of Changes in the Money Market
An decrease in the demand for money
An increase in the supply of money after the Fed buys bonds S1 r1 S1
SRAS
P2b P2 r2
P1b P1 D2 D1 D1 D2
AD1
AD2 M Q1 Q2 Y1 Y2 S1 S2 r1 S1
SRAS
P2b r2 P2
P1b P1 D1 D2 D1
AD1
AD2 Q1 Q2 M M’ Y1 Y2

21. 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.
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22. 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.
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23. 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.)
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24. 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.
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25. 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.
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26. 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.
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27. Money Market Equilibrium
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28. How Money Supply Changes affect GDP
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29. Money Supply vs. Interest Rates
Fed Increases
Money Supply r1
Interest
Rates
Fall r2 Md
Money
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