Question

Suppose the Central Bank conducts an open market purchase.

a) Show the effects of this on the bond market and money market by drawing a supply and demand diagram for each. Assume the liquidity effect is the only effect.

b) Looking at your diagram, immediately after the open market purchase (i.e. after the shifts you drew in the diagram but before the markets are at the new equilibria) would there be excess demand or excess supply in the money market and the bond market? Briefly explain.

c) Suppose in addition to the liquidity effect, there is a price level effect in this market. Briefly explain how the open market purchase would eventually affect the money market due to the price level effect

Answer 1

We investigate the case where Central Bank conducts an open market purchase. Such an action will increase the supply of money in the money market. With more money in hand people are likely to buy more bonds and thus, the bond market experiences an increase in the quantity of bonds via increased demand

a) Below are the two diagrams that show the effects of this on the bond market and money market. Money supply curve shifts to the right in the money market and demand function for bonds shifts to the right in the bond market.

b)Immediately after the open market purchase, there is an excess money supply in the money market and excess bond demand in the bond market. This is because the supply is increased in the money market and there is no change in interest rate so money demand is unchanged. Similarly, there is an increased demand but the price of bonds is unchanged so supply is not changed.

c) Accordingly, price of the bonds will rise and at the new equilibrium, both the bond price and bond quantity have increased. In money market, rate of interest will fall and this will increase the quantity of money demanded and supplied. This is the result of increased liquidity.

Suppose in addition to the liquidity effect, there is a price level effect in this market. This implies that in the transition to the long run as prices are free to adjusted, production constraints will force firms to raise price and so increased price level reduces the real money supply to the full. This implies money supply function will shift back to its original position and rate of interest will again reach i*.