Our next task is to explain what determines the domestic interest rate. We will address that issue in this chapter by examining equilibrium in domestic financial markets. We will see that the domestic interest rate is influenced by a variety of exogenous factors, as well as by the domestic price level. In the next chapter we will put together the labor market, goods market, and financial markets to show how the domestic price level and interest rate are simultaneously determined.

So far, we have not identified the financial asset with which the domestic interest rate is associated. We will assume that there are a total of three financial assets in our model: domestic money, domestic bonds, and foreign bonds. Money (the quantity of which in existence at any moment will be denominated M) will be taken to consist of currency issued by the central bank, since we assume that there are no commercial banks in this economy (and therefore no demand deposits, or checking accounts, which are usually part of the definition of money). Domestic bonds are debts issued by the domestic government, denominated in domestic currency. They are one-period bonds – that is, they have a one-period maturity and pay the variable interest rate i. Foreign bonds are similarly one-period bonds, but are denominated in foreign currency. Both types of bonds trade in well-organized secondary markets, and except when explicitly stated, we will suppose that domestic residents can hold foreign bonds, and foreign residents can hold domestic bonds.