Question

Prepare a concise response to the following prompt. For maximum credit, you should combine graphical and verbal reasoning in your response. Suppose that the Federal Reserve wishes to buy bonds from the public. a) How does this transaction affect the money supply? b) How does this transaction affect the interest rates? Answer this question in two ways: • Using a simple supply and demand analysis for bonds • Using the liquidity preference framework Do the two approaches yield consistent answers?

Answer 1

(a)

Fed's buying bonds will increase money supply.

(b)

(1) Bond demand-supply

Fed's bond purchase will increase the demand for bonds, shifting bond demand curve to right, increasing both price and quantity of bonds. Since bond price and interest rate are inversely related, higher bond price decreases interest rate.

In following graph, D0 and S0 are initial bond demand and supply curves, intersecting at point A with initial price P0 and quantity of bonds Q0. As D0 shifts right to D1, it intersects S0 at point B with higher price P1 and higher quantity Q1.

90 91 9

(2) Liquidity preference model (Money market)

Increase in demand for bonds will decrease the demand for money. A fall in money demand shifts money demand curve to left, decreasing interest rate.

In following graph, MD0 and MS0 are initial money demand and supply curves, intersecting at point A with initial interest rate r0 and quantity of money M0. As MD0 shifts left to MD1, it intersects MS0 at point B with lower interest rate r1.

i uso BUDE Mo Mo, MS

Both approaches result in consistent answer.