Chapter 26: Problem 5

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

Expert verified

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.

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