Graph walkthrough · Macro · Money market
The Fed buys bonds
The central bank buys government bonds from banks in an open market purchase.
Step 1 of 4 · Before the purchase
The horizontal axis is the quantity of money in the economy. The vertical axis is the nominal interest rate, what you give up by holding money instead of an interest-paying bond. Money demand slopes down. Money supply is a vertical line because the central bank sets it. They cross at E₀.
The chain in words
Step 1
Before the purchase
The horizontal axis is the quantity of money in the economy. The vertical axis is the nominal interest rate, what you give up by holding money instead of an interest-paying bond. Money demand slopes down. Money supply is a vertical line because the central bank sets it. They cross at E₀.
Step 2
Money supply shifts right
The central bank pays for the bonds with new reserves, and banks lend them out. The quantity of money rises, so money supply shifts right. At the old interest rate, people are holding more money than they want.
Step 3
The interest rate falls
People use the extra money to buy bonds. Bond prices rise, which means the interest rate falls. As the rate falls, holding money costs less, a movement along the money demand curve, until people are content to hold the larger money stock at E₁.
Step 4
From the money market to spending
The lower interest rate makes loans cheaper. Firms invest more and households borrow more, which raises aggregate demand. That is how an open market purchase reaches the rest of the economy.
Takeaway. An increase in the money supply lowers the nominal interest rate.
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Lesson: The Money Market