Central Bank Bond Purchase
The question
Assume the economy of Valmere is operating below full employment. To stimulate spending, the central bank of Valmere purchases government bonds on the open market. Show the short-run effect of this action on the money market, assuming all else is held constant. Show the effect on the Money Market graph.
Drag a curve, or use the arrow buttons. Want the free-play version with every control? Open this graph in the sandbox.
Central Bank Bond Purchase: the worked answer
On the Money Market graph, Money supply (MS) shifts right.
Why Money supply (MS) shifts right
An open-market purchase means the central bank buys bonds from banks and pays for them with newly created reserves. Bank reserves rise, so banks can lend more and the money supply increases at every interest rate. Because the central bank sets the money supply, the vertical MS line shifts to the right. Money demand is unchanged because the event does not alter the price level or real income in the short run.
What happens to the equilibrium
The equilibrium nominal interest rate falls as the quantity of money in the economy increases.
The mistake students make on this one
The most common wrong answer is shifting MS to the LEFT, because students hear "the central bank is buying" and picture the bank taking money in. The bank pays for those bonds with newly created reserves, so money flows out to banks and the public, which is an expansion of the money supply.
On exam day
On any open-market operation, ask which side of the trade the central bank is on and where the money ends up: the bank buys bonds and pays out new money, so MS shifts right.
How this is graded
The checker reads every curve's position before and after your answer. You are marked correct only when Money supply (MS) shifts right and every other curve on the Money Market graph stays where it started — the same standard an AP reader applies to a drawn graph: the right shift, and nothing extra. There is no AI involved; the rubric is the geometry.
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