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In December of the price had dropped to around How is that safer than individual bonds? If you had bought a 3-year individual bond in July of you'd be getting your entire principal back, not 5. Much of what he writes assumes investors are not going to hold bonds to maturity. Most bond holders who invest for income do hold the bonds to maturity. Even if interest rates drop and bond prices go up, there's really no point in selling the bonds before maturity because the interest you would get with a new bond would be lower than what you have now a bird in the hand.

Throw in transaction costs and you could end up losing money. For example, investment is one component of aggregate demand, and interest rates affect investment. Consumption may also be affected by changes in interest rates. For example, if interest rates fall, consumers can more easily obtain credit and thus are more likely to purchase cars and other durable goods. To simplify, we ignore this effect. If bond prices fall, interest rates go up. Higher interest rates tend to discourage investment, so aggregate demand will fall.

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. In contrast, an increase in the price of bonds lowers interest rates and makes investment in new capital more attractive. That change may boost investment and thus boost aggregate demand.

In Panel a , an increase in demand for bonds raises bond prices. Interest rates thus fall. Lower interest rates increase the quantity of investment demanded, shifting the aggregate demand curve to the right, from AD1 to AD2 in Panel b. In Panel c , an increase in the supply of bonds pushes bond prices down. Interest rates rise. The quantity of investment is likely to fall, shifting aggregate demand to the left, from AD1 to AD2 in Panel d.

Output and the price level fall from Y1 to Y2 and from P1 to P2, respectively. 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. An increase in the supply of bonds to S2 lowers bond prices to Pb2 in Panel c and raises interest rates. The higher interest rate, taken by itself, is likely to cause a reduction in investment and aggregate demand.

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. We will examine those events in subsequent chapters. Our focus in this chapter is on the way in which events that originate in financial markets affect aggregate demand. Foreign Exchange Markets Another financial market that influences macroeconomic variables is the foreign exchange market A market in which currencies of different countries are traded for one another.

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. Foreigners who want to purchase goods and services or assets in the United States must typically pay for them with dollars. United States purchasers of foreign goods must generally make the purchase in a foreign currency. An Egyptian family, for example, exchanges Egyptian pounds for dollars in order to pay for admission to Disney World.

A German financial investor purchases dollars to buy U. A family from the United States visiting India, on the other hand, needs to obtain Indian rupees in order to make purchases there. These transactions are accomplished in the foreign exchange market. The foreign exchange market is not a single location in which currencies are traded.

The term refers instead to the entire array of institutions through which people buy and sell currencies. 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. Major currency dealers are linked by computers so that they can track currency exchanges all over the world. On December 12, , for example, the dollar traded for There are as many exchange rates for the dollar as there are countries whose currencies exchange for the dollar—roughly of them.

Economists summarize the movement of exchange rates with a trade-weighted exchange rate An index of exchange rates. To calculate a trade-weighted exchange rate index for the U. Because trade-weighted exchange rates are so widely used in reporting currency values, they are often referred to as exchange rates themselves. We will follow that convention in this text.

Determining Exchange Rates The rates at which most currencies exchange for one another are determined by demand and supply. How does the model of demand and supply operate in the foreign exchange market? The demand curve for dollars relates the number of dollars buyers want to buy in any period to the exchange rate. An increase in the exchange rate means it takes more foreign currency to buy a dollar.

A higher exchange rate, in turn, makes U. That is likely to reduce the quantity of dollars they demand. Foreigners thus will demand fewer dollars as the price of the dollar—the exchange rate—rises. Consequently, the demand curve for dollars is downward sloping, as in Figure Here, equilibrium occurs at exchange rate E, at which Q dollars are exchanged per period. The supply curve for dollars emerges from a similar process. 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.

They supply dollars in exchange for foreign currency. 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. A higher exchange rate means that a dollar trades for more foreign currency. In effect, the higher rate makes foreign goods and services cheaper to U. People will thus supply more dollars at a higher exchange rate; we expect the supply curve for dollars to be upward sloping, as suggested in Figure In addition to private individuals and firms that participate in the foreign exchange market, most governments participate as well.

A government might seek to lower its exchange rate by selling its currency; it might seek to raise the rate by buying its currency. Although governments often participate in foreign exchange markets, they generally represent a very small share of these markets. The most important traders are private buyers and sellers of currencies.

Both of these motives must be considered to understand why demand and supply in the foreign exchange market may change. One thing that can cause the price of the dollar to rise, for example, is a reduction in bond prices in American markets. Suppose the supply of bonds in the U. Bond prices will drop. Lower bond prices mean higher interest rates. 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.

Panel b shows that the demand curve for dollars shifts from D1 to D2. Simultaneously, U. The fall in the price of U. Higher interest rates boost the demand and reduce the supply for dollars, increasing the exchange rate in Panel b to E2.

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