Question

If the Federal Reserve decided to increase the money supply by engaging in open market bond purchases from the non-bank public, explain what will happen to the equilibrium interest rate in the U.S. (in your description mention or show with a graph the change in the supply curve for loanable funds and the change in its intersection with the demand curve for loanable funds.

Answer 1

When the Federal Reserve wants to increase money supply in market through expansionary monetary policy, it tends to purchase bonds from open market and deposit payment into the accounts of the bond holders or buyers. This increases their inhand amount of money in exchange of those securities. With more money on hand, they will invest more and increase the economic activities. As a result, the bank interest rates will get lowered.

The below supply vs. demad graph would help in more precise clarification.

Below, as the supply curve (of monetary flow) increases from 13 billion dollars to 18 billion dollars (S1) by means of purchase of bonds from the public by Fed, the interest falls from 7% to 5%. On the contrary, if money flow in market is withdrawn (S2) by means of selling Fed bonds to the public, the interest rate gets higher to 9.5%