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Financial Markets and the Economy
Read Chapter 10 pages 204 – 220
I The Bond and Foreign Exchange Markets.
A) A financial market is a market where
funds accumulated by one group are made
available to another group.
B) The Bond Market
1) Bond prices and interest rates
a) The maturity date of a bond is the date
when the loan matures or comes due.
b) The face value of a bond is the amount the
issuer will have to pay on the maturity date
of the bond.
c) An interest rate is the payment made for
the use of money expressed as a percentage
of the amount borrowed.
d) Interest rate =
((Face value-bond price)/bond price) x 100
e) Example:
(($1,000-$950)/$950) x 100 = 5.3%
f) Note that a higher price corresponds to a
higher lower interest rate and a lower price
corresponds to higher interest rates.
2) The Bond Market and Macroeconomic
Performance.
a) When bond prices go up, real GDP and
the price level rise.
b) When bond prices go down, real GDP
and the price level may fall.
C) Foreign Exchange Markets
1) The foreign exchange market is a market
in which currencies of different countries
are traded with one another.
2) An exchange rate is the price of its
currency in terms of another currency.
Example: 121 Yen/$ is the price of a $ in
terms of yen.
3) A trade-weighted exchange rate is an index
of exchange rates.
4) Determining Exchange rates.
a) Demand curves relates the number of
dollars buyers want to buy in any period of
exchange.
b) Supply curve relates the number of dollars
sellers want to sell in any period of
exchange.
c) Higher exchange means U.S. products are
more expensive and reduces the demand for
them. Lower exchange is the opposite.
5) Exchange Rates and Macroeconomic
Performance.
a) Demand for currency comes from both a
demand for domestic products and a
demand for domestic assets.
b) If bond supply increases, then prices of
bonds will fall, interest rates will rise, and
there demand for currency from foreigners
will rise pushing up the exchange rate and
reducing aggregate demand for goods.
II Demand and Supply and Equilibrium in the
Money Market.
A) The demand for money.
1) The demand for money is the relationship
between the quantity of money people
want to hold and the factors that determine
that quantity.
2) Motives for holding money.
a) The transactions demand for money is
money people hold to pay for goods and
services they anticipate buying.
b) The precautionary demand for money is
money people hold for contingencies.
c) The speculative demand for money is the
money held in response to concern that
bond prices and the prices of other financial
assets might change.
B) Interest rates and the demand for money.
Holding money represents an opportunity
cost in the form of foregone interest
income.
C) The Demand curve for money shows the
quantity of money demanded at each
interest rate, all other things unchanged.
1) It slopes downward.
2) It shifts due to
a) Real GDP
b) The price level
c) Expectations
d) Transfer Costs
e) Preferences
D) The Supply of Money
1) The supply curve of money shows the
relationship between the quantity of money
supplied and the market interest rate, all
other determinants of supply unchanged.
2) Typically we assume the central bank has
complete control over the money supply
and thus the money supply curve is vertical
E) Equilibrium in the Market for Money.
1) The money market is the interactions
among institutions through which money is
supplied to individuals, firms and other
institutions that demand money.
2) Money Market equilibrium occurs at the
interest rate at which the quantity of money
demanded is equal to the quantity of money
supplied.
F) Effects of changes in the Money Market.
1) Illustration of an expansionary monetary
policy.
Fed expands the money supply by buying
bonds (I.e. handing out money), this
increases the demand for bonds, driving
up their price, reducing interest rates and
stimulating investment and thus aggregate
demand.