Answer to Question #46341 in Macroeconomics for Rita

Question

Assume that the treasury is currently running large surpluses (tax collections exceed new government spending). On a S/D diagram show the effect on Treasury Bond markets of using these surpluses to buy back outstanding treasury securities and reduce the governments' outstanding debt.

Answer 1

When the Fed starts buying T-bonds, effectively it pumps money into the system. Therefore the interest rate starts going down. As the interest rate is inversely related to the T-bond prices, their prices start going up, and their yields start going down. Also the due to demand for purchase, the price increases. The Fed does this when they want to reduce interest rate to stimulate the economy and at times of surplus.
The opposite happens when the Fed starts selling T-bonds and other bonds. When the Fed sells bonds in large amount in the market, their price starts going down and their yields start going up. As money supply is decreased, and yields increase the interest rate goes up. The Fed does this at times of budget deficit in order to raise fund to balance federal budget. The Fed never actually does this, however. The Fed only increases money supply, thereby increasing the prices of good and service citizens want to buy.