Central Bank Bond Sale
The question
The central bank of Ostrey conducts an open-market operation, selling government bonds to commercial banks and to the public. Assume the price level and real income are unchanged. Show the short-run effect of this action on the money market. 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 Sale: the worked answer
On the Money Market graph, Money supply (MS) shifts left.
Why Money supply (MS) shifts left
When the central bank sells bonds on the open market, buyers pay with reserves and deposits, and those funds are absorbed by the central bank rather than staying in the banking system. With fewer reserves, banks make fewer loans and create fewer new deposits, so the total quantity of money is smaller at every interest rate and the vertical MS line shifts to the left. Money demand does not move, because the price level and real income are held constant and nothing has changed about how people make payments.
What happens to the equilibrium
The equilibrium nominal interest rate rises as the quantity of money in the economy decreases.
The mistake students make on this one
The error students actually make here is shifting MD left, reasoning that "people handed over money to buy the bonds, so they demand less money." Handing money to the central bank removes it from circulation, which is a change in the quantity supplied; the willingness of households and firms to hold money at each interest rate is untouched.
On exam day
Sort every open-market operation by who ends up holding the money: the central bank selling bonds collects money and pulls it out of circulation, so MS shifts left and the interest rate rises.
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 left 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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