Question

Some years ago, the Fed simultaneously sold short-term Treasury securities and purchased long-term Treasury securities. What does this policy do to short-term and long-term interest rates?  You must provide appropriate bond market graphsand explainyour answer.  Label the graphsproperly.

Answer 1

In each graph, bond price (P) and quantity of bonds (Q) are depicted vertically and horizontally respectively. D0 and S0 are initial demand and supply curves for bonds, intersecting at point A with initial bond price P0 and quantity of bonds Q0.

(a) Short-term Treasury securities market

Fed selling short-term treasury securities will increase the supply of short-term treasury securities, shifting its market supply curve rightward. Short-term treasury securities price will decrease and quantity will increase. Since bond price and yield are inversely related, lower Short-term treasury securities price will increase their yield.

In following graph, S0 shifts right to S1, intersecting D0 at point B with lower price P0 and higher quantity Q0.

(b) Long-term Treasury securities market

Fed purchasing long-term treasury securities will increase the demand for long-term treasury securities, shifting its market demand curve rightward. Long-term treasury securities price will increase and quantity will increase. Since bond price and yield are inversely related, higher Long-term treasury securities price will decrease their yield.

In following graph, D0 shifts right to S1, intersecting S0 at point B with higher price P0 and higher quantity Q0.