Transcript Demand Function

Financial Markets:
Bonds and Foreign
Exchange
Bond Market: Supply and Demand




Bonds are bought
and sold on the open
market: supply and
demand
Shifts in S or D will
change Q and price
of bonds
Recall that bonds’
interest rates depend
on bonds’ prices
As bond prices rise,
bond interest rates
fall, and vice versa
Bond Market: Shifts

Supply of bonds
shifts when
–
–
–

Companies decide to
invest more
Governments run
deficits and need to
borrow
Central bank
intervenes
Demand for bonds
shifts when
–
–
–
People’s expectations
for inflation change
People’s expectations
of stock market
change
People save more or
less
Bond Prices and Foreign Exchange



S1
D1 D 2
Quantity of $s
Value of euro

Foreigners must buy dollars
in order to buy US bonds
Americans must buy foreign
currency in order to buy
foreign bonds
Changes in bond interest
rates affect foreign
exchange rates
If US interest rates rise, ALL
ELSE UNCHANGED,
foreigners will demand more
US bonds and therefore
more US dollars; Americans
will also hold on to dollars
more, so supply will
decrease
An increase in demand for
US dollars raises the value
of US dollars against the
foreign currency (and at the
same time lowers the value
of the foreign currency
against the dollar)
Value of $

S2
S1
S2
D2 D1
Quantity of euros
Foreign Exchange Rates Affect XN

When the dollar gains in
value against a foreign
currency,
–
–

When the dollar loses value
against a foreign currency
–
–


foreign products seem
cheaper to US consumers.
US products seem more
expensive to foreign
consumers
Foreign products seem more
expensive to US consumers
US products seem cheaper
to foreign consumers
So... when the dollar gains
value against a foreign
currency, American AD…
falls
When the dollar loses value
against a foreign currency,
American AD…
rises
Interest Rates and AD

When interest rates rise
– Investment falls
– Dollar gains in value
against other currencies
– Net Expotrs fall
– AD falls

When interest rates fall
– Investment rises
– Dollar loses in value
against other currencies
– Net Expotrs rise
– AD rises

So why is China currently
reluctant to let the value of
the yuan rise? Why does
the US want China to raise
the value of the yuan?
Scenario 1



Ben Bernanke
announces that next
year will be a tough
year for companies to
profit.
Show on the Bond
Market graph, the
likely effects of this
statement on bond
prices, interest rates,
and quantity.
All else unchanged,
how will this effect the
exchange rate of the
dollar?
Scenario 2




The war in Iraq causes the
federal government to
borrow huge amounts of
money on the bond
market.
Show on the Bond Market
graph, the likely effects of
this statement on bond
prices, interest rates, and
quantity.
All else unchanged, how
will this effect the
exchange rate of the
dollar?
What effect would this
borrowing have on GDP?
Scenario 3




The Japanese government
starts running a federal
surplus, and no longer sells
government bonds on the
Japanese bond market.
Show on the Bond Market
graph, the likely effects of
this statement on Japanese
bond prices, interest rates,
and quantity.
All else unchanged, how
will this effect the
exchange rate of the US
dollar?
What effect would this
Japanese government
policy have have on US
GDP?