Expansionary Policy: The Fed Buys Bonds
The central bank buys bonds, money supply rises, and the nominal interest rate falls, boosting spending.
Expansionary Policy: The Fed Buys Bonds
Money MarketThe central bank buys bonds, money supply rises, and the nominal interest rate falls, boosting 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.
Expansionary Policy: The Fed Buys 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 Buys Bonds
To ease policy, the central bank buys government bonds on the open market, paying with newly created reserves. This injects money into the economy, so the vertical money supply shifts right.
- 3
The Interest Rate Falls
At the old interest rate there is now a surplus of money, so the rate is bid down until MD and the new MS cross again. The nominal interest rate settles at a lower level. This is a movement down along the fixed money demand curve, not a shift of MD.
- 4
Spending Responds
With borrowing now cheaper, firms increase investment and households increase interest-sensitive consumption. This higher spending raises aggregate demand, the goal of expansionary monetary policy.
- 5
Prices Catch Up
Over the next few years the extra spending pushes prices up across the economy. Higher prices mean people need more cash for the same groceries and rent. Watch the money-demand line slide right, and the interest rate climb back toward where it started.
- 6
Money Is Neutral in the Long Run
Ten years out the interest rate is back near where it began, because how much cash people want to hold caught up to all the extra money the Fed made. The one lasting change is that prices are higher across the board. Printing money moved the price tags, not how much the economy can actually make.
Where it ends up
An open-market bond purchase shifts money supply right, lowering the nominal interest rate and stimulating 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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