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Week 6: Monetary Policy Imagine that the central bank decides to buy short-term treasury bonds

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Week 6: Monetary Policy

Imagine that the central bank decides to buy short-term treasury bonds. (Technically these would be notes but they are just like bonds except shorter.)

a. Show the effect of this in the market for short-term treasuries.  What happens to the price?  (Assume this has no effect on the expected inflation rate.)

b. Show the effect of this in the market for loanable funds.  What happens to the interest rate? (Keep in mind that we are talking about a short-term interest rate here.)

c. Recall that when the central bank does this, they buy the bonds with newly-created money, thus increasing the money supply.  What effect would you expect this to have on the prices of long-term bonds and why?  (You may want to review the "Fisher effect" from chapter 12.  You may assume that these purchases are not expected by the market.)