Question

Assume the demand for money curve is fixed and the Fed increases the money supply. The result is that the price of bonds a. rises. b. remains unchanged. c. falls. d. None of the above occurs.

Short answer

The correct answer is a. rises. The reason behind this is that when the Fed increases the money supply, there is more money available for lending, which results in lower interest rates. This, in turn, leads to an increase in the price of bonds. Hence, if the demand for money curve is fixed and the money supply is increased, the price of bonds rises.

Step-by-step solution

Understand the impact of changes in money supply on interest rates

When the Fed increases the money supply, it injects more money into the financial system. This makes money more easily available for lending, leading to lower interest rates in the market. With more available money, market participants have more funds to invest, which drives down the cost of borrowing or interest rates.

Relate declining interest rates to bond prices

A bond is a financial instrument that pays periodic interest payments to bondholders. Bonds are priced based on the present value of all future cash flows, including both interest payments and the principal repayment at the end of the bond's term. When interest rates decline, the present value of these cash flows increases, making bonds more valuable. Thus, the price of bonds should increase when interest rates fall.

Make the connection between increased money supply and bond prices

As we established that increased money supply leads to lower interest rates and lower interest rates lead to higher bond prices, we can conclude that an increase in the money supply, with a fixed demand for money, would result in higher bond prices.

Choose the correct option

Based on our analysis, we can choose the correct option from the list: a. rises. b. remains unchanged. c. falls. d. None of the above occurs. The correct answer should be: a. rises.

Key concepts

Money Supply

The concept of money supply refers to the total amount of money available within an economy at a given time. It includes both cash and money held in checking and savings accounts. When the Federal Reserve (Fed) decides to increase the money supply, it injects additional money into the economy.
This action usually aims to stimulate economic growth, especially during periods of recession. The Fed can increase the money supply through tools like purchasing government securities or lowering reserve requirements for banks.
Fostering a higher money supply helps increase liquidity. More money in circulation makes it easier for individuals and businesses to access funds. This enhanced liquidity can lead to lower interest rates, allowing businesses to invest and consumers to spend, thereby boosting economic activity.

Interest Rates

Interest rates are the cost of borrowing money, typically expressed as a percentage of the amount loaned. They play a crucial role in the economy, influencing decisions by consumers and businesses alike.
When the money supply increases, interest rates tend to fall because there is more money available in the system. Simply put, when money is abundant, lenders are more willing to offer loans at lower rates. This decrease in interest rates affects various economic activities.

• Consumers find it cheaper to finance large purchases, such as homes or cars.
• Businesses can borrow money at a lower cost to expand operations or invest in new technologies.
• The overall spending in the economy may rise, leading to economic growth.

However, one must be cautious, as overly low interest rates for an extended period can lead to inflation or create asset bubbles.

Bond Prices

Bond prices are inversely related to interest rates. When interest rates drop, bond prices tend to rise. But why does this occur? Bonds provide fixed interest payments to bondholders. If market interest rates fall, newly issued bonds would offer returns lower than existing ones.
This makes existing bonds, with their higher interest rates, more attractive, leading to increased demand and higher prices. Conversely, if interest rates were to rise, the opposite would occur, and bond prices would likely fall.
Understanding the bond market can be vital for investors as bond prices can fluctuate based on changes in monetary policy like adjustments in the money supply. Therefore, when the Fed increases the money supply, leading to lower interest rates, we often see the price of bonds increase as a result.