Notes On Money And Banking

Money and Banking
Old Exam Solutions - Chapter 5

Fill in the Blanks (NO EXPLANATIONS)

1. An increase in inflation expectations would (shift the bond demand curve left / shift the bond demand curve right / have no eﬀect on the bond demand curve) and (shift the bond supply curve left / shift the bond supply curve right / have no eﬀect on the bond supply curve).
2. An increase in inflation expectations lead to (an increase in / a decrease in / no eﬀect on / an ambiguous eﬀect on) bond prices.
3. Suppose China decides to rebalance its portfolio to include fewer long term US Treasury bonds.
As a result, long term US Treasury yields will (rise / fall / stay the same).
4. A decrease in incomes would shift the (money supply curve left / money supply curve right
/ money demand curve left / money demand curve right). Nominal interest rates would therefore (increase / decrease / stay the same).
5. Last year, in the US, there was a great deal of uncertainty about the health of the private, financial sector of the economy. As a result, yields on US Treasury bonds (increased / decreased
/ remained the same / have nothing to do with the private sector ).
(Market participants were demanding more and more US Treasury bonds.)
6. Bond prices tend to (increase / decrease / be uncertain) in a recession.
7. The purchase of bonds by the Fed would lead to a/an (increase / decrease) in (money supply
/ money demand ), and hence a/an (increase / decrease) in the interest rate.

1

SHORT ANSWERS
NO CREDIT WILL BE GIVEN FOR JUST STATING THE CORRECT ANSWER.
1. Graphically represent and explain the eﬀect of a recession on bond market equilibrium as predicted by what you tend to observe in the data. Make sure to briefly but clearly explain why the demand and/or supply curves shift.
In the data, one observes that interest rates tend to decline (bond prices increase) in recessions.
Following are the eﬀects on bond demand and supply:
Demand: Wealth and incomes tend to fall in recessions, lowering the demand for assets in general and bonds in particular. The bond demand curve shifts left, and exerts a downward pressure on bond prices (upward pressure on yields)
Supply: The eﬀects on the supply curve are complicated. There are fewer profitable investment opportunities in a recession which tends to decrease the supply of bonds. The bond supply curve shifts left, and exerts an upward pressure on bond prices (downward pressure on yields). On the other hand, budget deficits tend to increase in recessions which shifts the bond supply right.
Making the eﬀect on supply potentially ambiguous.
DATA: End up with interest rates being lower in recessions and bond prices being higher. Also know that demand shifts left. So, to get the observed increase in bond prices (decrease in yields), it must be that the supply curve shifted left and its shift was relatively greater than the demand shift. There is no ambiguity involved once you use the information in the question, which asks you to answer based on “as predicted by what you tend to observe in the data.” Below is the graph from the slides:
Bond Price
S’b
Sb

P*

D’b
Q*

2

Db
Quantity of Bonds

2. The most important way in which the Federal Reserve changes the money supply in the US is by buying and selling bonds. Graphically represent the eﬀect, of the Fed selling bonds, on interest rates using the bond demand—supply framework as well as the money demand—money supply framework. Do you get the same eﬀect on interest rates in both frameworks?
In the bond market, the eﬀect of the Fed selling bonds is to shift the bond demand curve left.
At any given price, there was a certain demand for bonds and now there is a lower demand for bonds. In other words, there is now a (big) market participant that does not wish to hold bonds, so demand decreases. As a result bond prices decrease and interest rates increase.

In the money market, the eﬀect of the Fed selling bonds is to decrease money supply. As private agents pay the Fed for

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