9: Financial Markets, Interest Rates, Foreign Exchange Rates and AD

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In this chapter we will explore:

9.1 Portfolio choices between money and other assets
9.2 Bond prices, yields, and interest rates
9.3 The demand for money balances
9.4 Financial market equilibrium and interest rates
9.5 Interest rates and foreign exchange rates
9.6 Interest rates, exchange rates, and aggregate demand
9.7 The monetary transmission mechanism

This chapter continues our study of the effects of money and financial markets on economic activity. In Chapter 8, we examined money and the supply of money created by the banking system. The money supply was defined as the non-bank public’s holdings of currency and bank deposits. In this chapter, we will see that the non-bank public’s holdings of money balances arise from decisions about the management of wealth.

Money balances are one asset in a portfolio of assets. People choose to hold some of their financial wealth as money and some in other financial assets. These choices create a demand for money balances, which we will examine in detail.

The demand for money balances and the supply of money balances form the money market. Equilibrium between supply and demand in the money market determines the interest rate. That interest rate has important effects on planned expenditure, aggregate demand, output, and employment directly and through its effect on the foreign exchange rate.

We start with a brief discussion of portfolio choice and the prices of financial assets.