The Fed sells bonds

The chain in words

1. Step 1

   Before the sale

   The horizontal axis is the quantity of money. The vertical axis is the nominal interest rate. Money demand slopes down and money supply is vertical. The market is at E₀.

2. Step 2

   Money supply shifts left

   Buyers pay for the bonds with money, which leaves the banking system. The quantity of money falls, so money supply shifts left. At the old interest rate, people want to hold more money than exists.

3. Step 3

   The interest rate rises

   To rebuild money holdings, people sell bonds. Bond prices fall and the interest rate rises. At the higher rate, holding money costs more, so people economize on it, a movement along money demand, until the market clears at E₁ with a higher interest rate.

Takeaway. A decrease in the money supply raises the nominal interest rate.

Draw it yourself

More on the money market graph