Question 2 - Supply and Demand in the Bond Market Suppose that the demand curve and supply curve for one-year discount Treasury bonds with a face value of $1,000 are represented by the following equations: Pd = 1200 0.75Bd Ps = 500 + Bs

1. Given the above information, address the following: (a) What is the expected equilibrium price and quantity of bonds in this market? (b) Given your answer to the previous part, what is the equilibrium interest rate in this market? (c) Plot both curves and highlight the above equilibrium on the plot. For simplicity, let the y-axis denote the bond price.

2. Suppose that, as a result of monetary policy actions, the Federal Reserve buys 100 bonds through its open market operations. Assume that bond and money demand are held constant.

Based on this new information, address the following: (a) How does the Federal Reserve policy affect the bond supply equation? (b) Calculate the effect of the Federal Reserves action on the equilibrium interest rate in this market. (c) How did the Federal Reserve policy impact the equilibrium interest rate? Did it go up or down as a result? Briefly explain.

3. The above demonstrates the liquidity effect. However, assume now that the bond demand changes immediately due to the expected inflation effect. (a) What happens to the demand curve in this case? (b) Suppose this demand shift corresponds to 50 bonds. How does this shift impact the equilibrium interest rate? (c) What does it say about the liquidity effect?