Key Problem Set #5
Interest Rate Determination in US Treasury Market
Objectives
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Use the bond market diagram to analyze interest rates
Understand how the liquidity preference framework explains the effect of the money
supply on interest rates
Question
1. Currently the Treasury is issuing a significant volume of bonds, notes, and bills to
finance the ballooning government deficit. The Federal Reserve has been
purchasing Treasuries in the open market in order to keep interest rates low.
a. Use the Treasury Market Workspace to show and explain why the actions
of the Treasury should cause interest rates to rise.
The deficit is increasing either because of reductions in tax revenues or increases in
government expenditures. This causes the Treasury to issue bill, notes, and bonds in order
to finance the deficit. The increase in the bonds issued causes the supply of bonds to
increase as shown by the shfit to the right. This in turn causes interest rates to increase as
the price decreases.
b. Use the Treasury Market Workspace to show and explain why the actions
of the Fed should should cause interest rates to fall.
If at the same time the Fed intervenes by buying significant amounts of Treasuries, then
the demand for bonds increases which could cause the interest rate to go back to the
previous rate. The process whereby the Treasury issues bonds and then they are
purchased in the open market by the Federal Reserve is the process whereby we print
money in the United States.
2. The Federal Reserve creates money by buying US Treasuries. If the Fed makes
large purchases of Treasuries and thus increases the money supply,
a. Use the Liquidity Preference framework to show and explain why interest
rates might initially decline as the Fed increases the money supply.
The liquidity effect is the initial decrease in interest rates caused when the Federal
Reserve increases the money supply.The increase in the money supply causes interest
rates to decrease.
b. Explain why the income-effect, price-level effect, and expected-inflation
effects might eventually cause interest rates to rise.
The increase in the money supply and initial decrease in the interest rate would likely
stimulate the eonomy. This increase in output would probably increase income. It could
also lead people to expect prices to increase. The larger incomes and higher prices cause
the transaction demand for money to increase. This could offset the initial decrease in the
interest rates due to the liquidity effect. If the income, price-level, and expected-inflation
effects were large enough, they could actually cause interest rates to rise as shown in the
diagram below: