Financial Markets: Financial Markets: Bonds and Foreign Bonds and Foreign

ExchangeExchange

Bond Market: Supply and DemandBond Market: Supply and Demand Bonds are bought Bonds are bought

and sold on the open and sold on the open market: supply and market: supply and demanddemand

Shifts in S or D will Shifts in S or D will change Q and price change Q and price of bondsof bonds

Recall that bonds’ Recall that bonds’ interest rates depend interest rates depend on bonds’ priceson bonds’ prices

As bond prices rise, As bond prices rise, bond interest rates bond interest rates fall, and vice versafall, and vice versa

Bond Market: ShiftsBond Market: Shifts Supply of bonds Supply of bonds

shifts whenshifts when– Companies decide to Companies decide to

invest moreinvest more– Governments run Governments run

deficits and need to deficits and need to borrowborrow

– Central bank Central bank intervenesintervenes

Demand for bonds Demand for bonds shifts whenshifts when

– People’s expectations People’s expectations for inflation changefor inflation change

– People’s expectations People’s expectations of stock market of stock market changechange

– People save more or People save more or lessless

Bond Prices and Foreign ExchangeBond Prices and Foreign Exchange Foreigners must buy dollars Foreigners must buy dollars

in order to buy US bondsin order to buy US bonds Americans must buy foreign Americans must buy foreign

currency in order to buy currency in order to buy foreign bondsforeign bonds

Changes in bond interest Changes in bond interest rates affect foreign exchange rates affect foreign exchange ratesrates

If US interest rates rise, ALL If US interest rates rise, ALL ELSE UNCHANGED, ELSE UNCHANGED, foreigners will demand more foreigners will demand more US bonds and therefore more US bonds and therefore more US dollars; Americans will US dollars; Americans will also hold on to dollars more, also hold on to dollars more, so supply will decreaseso supply will decrease

An increase in demand for US An increase in demand for US dollars raises the value of US dollars raises the value of US dollars against the foreign dollars against the foreign currency (and at the same currency (and at the same time lowers the value of the time lowers the value of the foreign currency against the foreign currency against the dollar)dollar)

S1S2

D2D1

Valu

e o

f $

Quantity of $s

S2S1

D1D2

Valu

e o

f eu

ro

Quantity of euros

Foreign Exchange Rates Affect XForeign Exchange Rates Affect XNN

When the dollar gains in When the dollar gains in value against a foreign value against a foreign currency, currency,

– foreign products seem foreign products seem cheaper to US consumers.cheaper to US consumers.

– US products seem more US products seem more expensive to foreign expensive to foreign consumersconsumers

When the dollar loses value When the dollar loses value against a foreign currencyagainst a foreign currency

– Foreign products seem more Foreign products seem more expensive to US consumersexpensive to US consumers

– US products seem cheaper US products seem cheaper to foreign consumersto foreign consumers

So... when the dollar gains So... when the dollar gains value against a foreign value against a foreign currency, American AD… currency, American AD… fallsfalls

When the dollar loses value When the dollar loses value against a foreign currency, against a foreign currency, American AD… American AD… risesrises

Interest Rates and ADInterest Rates and AD When interest rates riseWhen interest rates rise

– Investment fallsInvestment falls– Dollar gains in value Dollar gains in value

against other currenciesagainst other currencies– Net Expotrs fallNet Expotrs fall– AD fallsAD falls

When interest rates fallWhen interest rates fall– Investment risesInvestment rises– Dollar loses in value Dollar loses in value

against other currenciesagainst other currencies– Net Expotrs riseNet Expotrs rise– AD risesAD rises

So why is China currently So why is China currently reluctant to let the value of reluctant to let the value of the yuan rise? Why does the yuan rise? Why does the US want China to raise the US want China to raise the value of the yuan?the value of the yuan?

Scenario 1Scenario 1 Ben Bernanke Ben Bernanke

announces that next announces that next year will be a tough year will be a tough year for companies to year for companies to profit.profit.

Show on the Bond Show on the Bond Market graph, the Market graph, the likely effects of this likely effects of this statement on bond statement on bond prices, interest rates, prices, interest rates, and quantity.and quantity.

All else unchanged, All else unchanged, how will this effect the how will this effect the exchange rate of the exchange rate of the dollar?dollar?

Scenario 2Scenario 2 The war in Iraq causes the The war in Iraq causes the

federal government to federal government to borrow huge amounts of borrow huge amounts of money on the bond market.money on the bond market.

Show on the Bond Market Show on the Bond Market graph, the likely effects of graph, the likely effects of this statement on bond this statement on bond prices, interest rates, and prices, interest rates, and quantity.quantity.

All else unchanged, how All else unchanged, how will this effect the will this effect the exchange rate of the exchange rate of the dollar?dollar?

What effect would this What effect would this borrowing have on GDP?borrowing have on GDP?

Scenario 3Scenario 3 The Japanese government The Japanese government

starts running a federal starts running a federal surplus, and no longer sells surplus, and no longer sells government bonds on the government bonds on the Japanese bond market.Japanese bond market.

Show on the Bond Market Show on the Bond Market graph, the likely effects of graph, the likely effects of this statement on Japanese this statement on Japanese bond prices, interest rates, bond prices, interest rates, and quantity.and quantity.

All else unchanged, how All else unchanged, how will this effect the will this effect the exchange rate of the exchange rate of the US US dollardollar??

What effect would this What effect would this Japanese government Japanese government policy have have on policy have have on US US GDPGDP??