Explain and illustrate the relationship between a change in demand for or supply of bonds and macroeconomic activity.
In their daily operations and in pursuit of new projects, institutions such as firms and governments often borrow. An interest ratePayment made for the use of money, expressed as a percentage of the amount borrowed. Whatever the period until it matures, and whatever the face value of the bond may be, its issuer will attempt to sell the bond at the highest possible price.
The equilibrium price for bonds is determined where the demand and supply curves intersect.
The connection between the bond market and the economy derives from the way interest rates affect aggregate demand. Figure 10.2 "Bond Prices and Macroeconomic Activity" shows how an event in the bond market can stimulate changes in the economy’s output and price level. An increase in the demand for bonds to D2 in Panel (a) raises the price of bonds to Pb2, which lowers interest rates and boosts investment.
An increase in the supply of bonds to S2 lowers bond prices to Pb2 in Panel (c) and raises interest rates. In thinking about the impact of changes in interest rates on aggregate demand, we must remember that some events that change aggregate demand can affect interest rates. Another financial market that influences macroeconomic variables is the foreign exchange marketA market in which currencies of different countries are traded for one another., a market in which currencies of different countries are traded for one another. Foreigners who want to purchase goods and services or assets in the United States must typically pay for them with dollars.
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 rateAn index of exchange rates., which is an index of exchange rates. The rates at which most currencies exchange for one another are determined by demand and supply. The demand curve for dollars relates the number of dollars buyers want to buy in any period to the exchange rate.
The equilibrium exchange rate is the rate at which the quantity of dollars demanded equals the quantity supplied. In addition to private individuals and firms that participate in the foreign exchange market, most governments participate as well.
One thing that can cause the price of the dollar to rise, for example, is a reduction in bond prices in American markets. In Panel (a), an increase in the supply of bonds lowers bond prices to Pb2 (and thus raises interest rates).
An increase in the interest rate tends to decrease the quantity of investment demanded and, hence, to decrease aggregate demand. The only problem with the plan was that the interest rate on 30-year bonds actually fell over the next year. Perhaps another thing he did not understand was that when he heard that the Federal Reserve was raising rates in 2004 that this referred to the federal funds rates, a very short-term interest rate. 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 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.
An interest rateinterest ratePayment made for the use of money, expressed as a percentage of the amount borrowed. Figure 10.2, “Bond Prices and Macroeconomic Activity” shows how an event in the bond market can stimulate changes in the economy’s output and price level.
Another financial market that influences macroeconomic variables is the foreign exchange marketforeign exchange marketA market in which currencies of different countries are traded for one another., a market in which currencies of different countries are traded for one another. Economists summarize the movement of exchange rates with a trade-weighted exchange ratetrade-weighted exchange rateAn index of exchange rates., which is an index of exchange rates.


They have a face value (usually an amount between $1,000 and $100,000) and a maturity date.
Bond prices are perfectly flexible in that they change immediately to balance demand and supply. For example, investment is one component of aggregate demand, and interest rates affect investment. That increases aggregate demand to AD2 in Panel (b); real GDP rises to Y2 and the price level rises to P2.
The higher interest rate, taken by itself, is likely to cause a reduction in investment and aggregate demand. Since changes in exports and imports affect aggregate demand and thus real GDP and the price level, the market in which currencies are traded has tremendous importance in the economy.
United States purchasers of foreign goods must generally make the purchase in a foreign currency. The term refers instead to the entire array of institutions through which people buy and sell currencies.
When people and firms in the United States purchase goods, services, or assets in foreign countries, they must purchase the currency of those countries first. A government might seek to lower its exchange rate by selling its currency; it might seek to raise the rate by buying its currency. Both of these motives must be considered to understand why demand and supply in the foreign exchange market may change. Figure 10.4 "Shifts in Demand and Supply for Dollars on the Foreign Exchange Market" illustrates the effect of this change. Higher interest rates boost the demand and reduce the supply for dollars, increasing the exchange rate in Panel (b) to E2.
A decrease in the interest rate increases the quantity of investment demanded and aggregate demand. While other short-term interest rates moved with the federal funds rate in 2004, long-term rates did not even blink. Figure 10.4, “Shifts in Demand and Supply for Dollars on the Foreign Exchange Market” illustrates the effect of this change.
For example, if interest rates fall, consumers can more easily obtain credit and thus are more likely to purchase cars and other durable goods.
These pieces of paper are bonds, and the company, as the issuer, promises to make a single payment. Bonds can be resold at any time, but the price the bond will fetch at the time of resale will vary depending on conditions in the economy and the financial markets. An increase in borrowing, all other things equal, increases the supply of bonds to S2 and forces the price of bonds down to $900. Suppose, for example, that the initial price of bonds is $950, as shown by the intersection of the demand and supply curves in Figure 10.1 "The Bond Market".
A fall in aggregate demand, other things unchanged, will mean fewer jobs and less total output than would have been the case with lower rates of interest.
Our focus in this chapter is on the way in which events that originate in financial markets affect aggregate demand. An Egyptian family, for example, exchanges Egyptian pounds for dollars in order to pay for admission to Disney World. It includes a hotel desk clerk who provides currency exchange as a service to hotel guests, brokers who arrange currency exchanges worth billions of dollars, and governments and central banks that exchange currencies. There are as many exchange rates for the dollar as there are countries whose currencies exchange for the dollar—roughly 200 of them. Although governments often participate in foreign exchange markets, they generally represent a very small share of these markets.
These developments in the bond and foreign exchange markets are likely to lead to a reduction in net exports and in investment, reducing aggregate demand from AD1 to AD2 in Panel (c).
Lower interest rates in the United States will make financial investments in the United States less attractive to foreigners.


Suppose, for example, that the initial price of bonds is $950, as shown by the intersection of the demand and supply curves in Figure 10.1, “The Bond Market”. To understand these relationships, let us look more closely at bond prices and interest rates.
The difference between the face value and the price is the amount paid for the use of the money obtained from selling the bond. Sellers of newly issued bonds are borrowers—recall that corporations, the federal government, and other institutions sell bonds when they want to borrow money. We will assume that all bonds have equal risk and a face value of $1,000 and that they mature in one year. In contrast, an increase in the price of bonds lowers interest rates and makes investment in new capital more attractive.
Lower interest rates increase the quantity of investment demanded, shifting the aggregate demand curve to the right, from AD1 to AD2 in Panel (b). Major currency dealers are linked by computers so that they can track currency exchanges all over the world.
Because trade-weighted exchange rates are so widely used in reporting currency values, they are often referred to as exchange rates themselves. The supply of dollars on the foreign exchange market thus reflects the degree to which people in the United States are buying foreign money at various exchange rates.
What he did not understand was how expensive guessing incorrectly the direction of interest rates would be when he decided to buy into an “inverse bond” fund. If only Thomas had known both the relationship between bond prices and interest rates and the direction of interest rates! Now suppose that borrowers increase their borrowing by offering to sell more bonds at every interest rate.
That makes them more attractive to buyers of bonds and thus increases the quantity demanded.
Foreigners thus will demand fewer dollars as the price of the dollar—the exchange rate—rises. That, in turn, lowers the equilibrium price of bonds—to $900 in Figure 10.1 "The Bond Market". Consequently, the demand curve for dollars is downward sloping, as in Figure 10.3 "Determining an Exchange Rate". Foreign financial investors, attracted by the opportunity to earn higher returns in the United States, will increase their demand for dollars on the foreign exchange market in order to purchase U.S.
This development in the foreign exchange market reinforces the impact of higher interest rates we observed in Figure 10.2 "Bond Prices and Macroeconomic Activity", Panels (c) and (d). That, in turn, lowers the equilibrium price of bonds—to $900 in Figure 10.1, “The Bond Market”. Consequently, the demand curve for dollars is downward sloping, as in Figure 10.3, “Determining an Exchange Rate”. This development in the foreign exchange market reinforces the impact of higher interest rates we observed in Figure 10.2, “Bond Prices and Macroeconomic Activity”, Panels (c) and (d). Thus, the negative relationship between price and quantity demanded and the positive relationship between price and quantity supplied suggested by conventional demand and supply curves holds true in the market for bonds. Assuming other determinants of aggregate demand remain unchanged, higher interest rates will tend to reduce aggregate demand and lower interest rates will tend to increase aggregate demand.
Increases in investment and net exports imply a rightward shift in the aggregate demand curve from AD1 to AD2.



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