1. Financial Markets: Bonds and Foreign Exchange

2. 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

3. 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

4. Bond Prices and Foreign Exchange  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) S1S1 S2S2 D2D2 D1D1 Value of $ Quantity of $s S2S2 S1S1 D1D1 D2D2 Value of euro Quantity of euros

5. Foreign Exchange Rates Affect X N  When the dollar gains in value against a foreign currency, –foreign products seem cheaper to US consumers. –US products seem more expensive to foreign consumers  When the dollar loses value against a foreign currency –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

6. 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?

7. 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?

8. 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?

9. 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?