Contractionary Policy: The Fed Sells Bonds
The central bank sells bonds or raises reserves, money supply falls, and the nominal interest rate rises to cool spending.
Contractionary Policy: The Fed Sells Bonds
Money MarketThe central bank sells bonds or raises reserves, money supply falls, and the nominal interest rate rises to cool spending.
Start at Equilibrium
The money market begins in equilibrium where money demand (MD) meets the vertical money supply (MS). The nominal interest rate sits where the two curves cross.
Now try it yourself: shift the curves in a graded FRQ drill, or open this graph in the free sandbox.
Contractionary Policy: The Fed Sells Bonds, step by step
- 1
Start at Equilibrium
The money market begins in equilibrium where money demand (MD) meets the vertical money supply (MS). The nominal interest rate sits where the two curves cross.
- 2
The Fed Sells Bonds
To fight inflation, the central bank sells government bonds and pulls the payment out of circulation, or raises the reserve requirement. Either way the money supply drops, so the vertical MS shifts left.
- 3
The Interest Rate Rises
At the old rate there is now a shortage of money, so the rate is bid up until MD and the new MS cross again. The nominal interest rate settles higher. This is a movement up along the fixed money demand curve, not a shift of MD.
- 4
Spending Slows
With borrowing now more expensive, firms cut investment and households cut interest-sensitive consumption. This lower spending reduces aggregate demand and eases inflationary pressure.
- 5
Prices Cool and Money Demand Slides Left
Over the next couple of years the slower spending does its job and those fast price increases finally cool off. Because the contractionary policy pulls prices down, the same basket of purchases now takes fewer dollars, so money demand MD shifts left. Watch the interest rate ease back down: with money demand lower, the MD line now meets the unchanged money supply (MS) at a lower point.
- 6
Ten Years Out: Money Is Neutral
By now the interest rate has settled back down near where it started, so borrowing feels normal again. The one lasting mark of the Fed's bond sale is that prices end up lower than they otherwise would have been. That is monetary neutrality: in the long run the Fed's move changes prices, not how much borrowing truly costs or how much the economy actually makes.
Where it ends up
An open-market bond sale shifts money supply left, raising the nominal interest rate and restraining investment and consumption.
Now draw it yourself
Same graph, graded on whether you move the right curve and leave the rest alone.
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