Question

a) Draw a supply and demand curve for US government bonds.

b) Show and explain what the effect expansionary monetary policy, using open market operations, will have on equilibrium.

c) Show and explain what the effect of contractionary monetary policy, using open market operations, will have on equilibrium.

d) Explain what the Fed should do if the interest rate is below its target rate? Or above?

Answer 1

(a) In following graph, bond price (P) and quantity of bonds (Q) are depicted vertically and horizontally respectively. D0 and S0 are initial demand and supply curves for bonds, intersecting at point A with initial price P0 and initial quantity Q0.

(b) An expansionary monetary policy is conducted using open market purchase of bonds, which will increase the supply of bonds. Bond supply curve will shift rightward, decreasing price and increasing quantity. In following graph, S0 shifts right to S1, intersecting D0 at point B with lower price P1 and higher quantity Q1.

(c) A contractionary monetary policy is conducted using open market sale of bonds, which will decrease the supply of bonds. Bond supply curve will shift leftward, increasing price and decreasing quantity. In following graph, S0 shifts left to S1, intersecting D0 at point B with higher price P1 and lower quantity Q1.

(d) If actual interest rate is below the target rate, Fed has to increase interest rate by decreasing money supply, using contractionary monetary policy by open market sale of bonds. If actual interest rate is above the target rate, Fed has to decrease interest rate by increasing money supply, using expansionary monetary policy by open market purchase of bonds.