Question

Using a graph of the bond market, show the effects of quantitative easing. Assume the Fed purchases government securities and the risk premium remains constant, how does this move affect the corporate bond market. Will it increase, decrease, or neutralize Corporate bond demand, supply, and interest rate. explain the scenario for each of them.

Answer 1

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Question:

Answer:

Monetary Policy:

It is policy adopted by the central government to manage (increasing or decreasing) the money supply. There are many tools of monetary policy by which the central bank increase or decrease the money supply in the economy. The main tools are : discount rate, purchasing or selling of government securities, reserve requirement. There are two type of monetary policy; first is expansionary and second is  contractionary.

Quantity Easing:

Quantitative easing is part of expansionary monetary policy by which its purchase the government securities from the open market through Open Market Operation (OMO). Its increase the money supply in the economy and decrease the interest rate and money become more cheaper. Cheaper money increased the demand of money.

Now come on the question:

The Fed purchases government securities and the risk premium remains constant. This expansionary monetary policy will affect the bond market. It will affect the bond price, interest rate, demand and supply of band etc.

Impact on demand and supply of bond:

When the central bank will purchase the US government securities then it will increase the demand of bond in the bond market

Bond price:

Because purchasing the government securities increase the interest rate. So, increasing interest demand rises for older bonds sold at a higher coupon rate and increased the price of money. In the simple term as per the demand-supply theory, when demand increase then price increase and vice-versa.

Interest rate:

When Fed purchases the government securities then its increase the money the money supply and increasing money supply decrease the interest rate.

Effects of quantitative easing:

Quantity easing increase the money supply, demand of bond, and price of bond and decrease the interest rate.

Now we understand all this things through a graph:

Lets assume currently bond market is at equilibrium at point "E0" where quantity demand of bond is "Q0' and price level of bond is "P0". Now as per the question, the fed purchase the US government securities that increase the demand of bond and decrease the interest rate (we have seen above about the quantity easing and monetary policy). Increasing demand shift the demand curve upward from "D0D0 to "D1D1" . Now new equilibrium point is "E1", demand of bond is increased by "Q0" to "Q1" and price of bond also increased from "P0" to "P1". "S0" is supply curve.

Graph: I have attached a graph below, please find it.

Thank You