Question

Using a graph and in your own words, explain how a change in open market purchases affects money supply and the nominal interest rate.

Answer 1

When governement undertakes an open market purchase of government bonds, it leads to an increase in money supply in the economy. At the same interest rate and price level, an open market purchase increase real money supply too. An increase in money supply keeping other things at the initial level decreases the nominal interest rate too. This can be seen the diagram below. The initial equilibrium is at point A. The initial interest rate is i.  At the initial interest rate i, real money supply has increased while real money demand remains at the initial level. So Money supply curve shown by MS / P will shift to right to MS' / P. Consequently, nominal interest rate will fall to i'.The final equilibrium point will be B as shown in the diagram where the money supply has increased and nominal interest rate has fallen. . Thus expansionary monetary policy (i.e. open market purchase) will cause a decrease in average interest rates in an economy.

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