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Economics (MindTap Course List)

13th Edition
Roger A. Arnold
ISBN: 9781337617383

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Economics (MindTap Course List)

13th Edition
Roger A. Arnold
ISBN: 9781337617383
Textbook Problem

Draw both the money market and bond market in equilibrium. Next, explain, and show diagrammatically, what happens to the interest rate and the price of bonds as a result of the Fed’s increasing the money supply.

To determine

The relation between the bond price and the interest rate.

Explanation

The inverse relation between the bond price and its interest rate is shown in the figure below:

images

According to the diagram, initially, the money market is in equilibrium at ‘a’ with the bond price PB1 and the interest rate of 5 percent.  When the Fed increases the money supply, the supply curve shifts to the right from S1 to S2 (shown in Panel (a)). This creates a money surplus in the market, and the individual buys more bonds and the demand for bond  will rise. Then, the demand curve will shift from D1 to D2 (shown in Panel (b)). This increased demand creates a shortage of bond at PB1 price. Then, both markets dislocate from the equilibrium. The increased demand of bond pushes its price up, and then the interest rate will decline. Finally, the money market will be located at ‘b’ with 4 percent interest rate and the bond market PB2 price.

Concept

Bond price: Bond price is the present value of a bond compared to its future promises of pay. It is inversely related to its interest rate.

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