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9: Financial markets, interest rates, foreign exchange rates and AD

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    Interest rates are everywhere. They provide income to lenders and impose costs on borrowers. Many types of bank and near-bank deposits pay interest income to their holders, as do guaranteed investment certificates (GICs) and bonds issued by businesses and governments and other income paying assets. These are assets to holders and liabilities to issuers in terms of interest payments and redemptions.

    Households, businesses and governments borrow using consumer loans, credit cards, lines of credit, mortgages, leases, bonds and other forms of debt. The interest rate attached to these borrowings is a cost of financing expenditures not covered by current income.

    The interest rate links financial markets to markets for goods and services. But what is 'the interest rate'? There are different interest rates attached to different forms of borrowing. There are different spectrums of interest rates based on the terms of the loan and the perceived risk of default. However, it is usually the case that interest rates across a spectrum rise or fall together. Changes in 'the interest rate' describe these shifts up or down across the spectrum for all assets.

    This chapter addresses two key questions:

    1. How is the interest rate determined?
    2. How does the interest rate affect aggregate demand?

    Explaining why the public decides to hold some wealth in money balances rather than other types of financial assets is the first step.

    This page titled 9: Financial markets, interest rates, foreign exchange rates and AD is shared under a CC BY-NC-SA license and was authored, remixed, and/or curated by Douglas Curtis and Ian Irvine (Lyryx) .

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