Question

1. Recently the Federal Reserve began a plan to begin selling off bonds:
   1. Graphically show the effect on the value of money when the fed engages in this strategy. Be sure to note any inflation or deflation seen in the market in the appropriate location on the graph.

Answer 1

When the Federal Reserve engages in selling off bonds, this reduces the quantity of money in circulation, i.e., decreasing the money supply. Graphically, it is shown as a leftward shift of LM curve. Due to this, the value of money increases, the interest rate increases. This also leads to a decrease in the aggregate demand because decrease in money supply will lead to decrease in consumer spending, and hence the AD curve shifts leftward. As we can see, the prices decrease from P1 to P2. Hence monetary contraction is used to dampen inflation.