Question

1. Suppose that the US Federal Reserve conducts an open market purchase of bonds. Assume a Keynesian framework: a. Use a graph of the supply and demand for bonds to show what would happen to the price of U.S. bonds. Be sure to label your graph carefully. (10 points) b. Use a graph of the money market to show what would happen to U.S. interest rates. Be sure to label your graph carefully (10 points) c. Explain what would happen to aggregate demand as a consequence. Focus on the effects on investment. (You only need to note the direction of the changes.) (5 points)

Answer 1

(a) An open market purchase of bonds will increase the demand for bonds, shifting demand curve rightward which will increase both the price and quantity of bonds traded. In following graph, price (P) and quantity (Q) of bonds are measured vertically and horizontally respectively. D0 & S0 are initial demand & supply curves of bonds, intersecting at point A with initial price P0 and quantity of bonds traded Q0. As demand for bonds rises, D0 shifts right to D1, intersecting S0 at point B with higher price P1 and higher quantity traded Q1.

(b) An open market purchase will increase money supply, shifting money supply curve rightward and lowering interest rate. In following graph, interest rate (r) and quantity of money (M) are measured vertically & horizontally respectively. MD0 & MS0 are initial money demand and money supply curves intersecting at point A with initial interest rate r0 and quantity of money M0. As money supply rises, MS0 shifts right to MS1, intersecting MD0 at point B with lower interest rate r1 and higher quantity of money M1.

(c) As interest rate falls due to higher money supply, investment demand increases, therefore aggregate demand increases, raising price level and real GDP in short run.