3. A month later, Bob buys a $1000 government bond from the Fed with this money.

Question

3. A month later, Bob buys a $1000 government bond from the Fed with this money. A) What happens to the money supply (M1)? Does it increase or decrease? By how much? The money supply would B) How would this impact Bob's future spending? Would it increase or decrease? C) Under what circumstances would Bob be likely to buy bonds ? (describe the economy, his perceptions) D) 5 years later Bob sells the bond for $1000 and buys $1000 in common stock. Describe the differences in Bob's investment portfolio. (how does it differ; what are the risks; what are his returns)

Explanation / Answer

QUESTION:
A month later, Bob buys a $1000 government bond from the Fed with this money. A) What happens to the money supply (M1)? Does it increase or decrease? By how much? The money supply would B) How would this impact Bob's future spending? Would it increase or decrease? C) Under what circumstances would Bob be likely to buy bonds ? (describe the economy, his perceptions) D) 5 years later Bob sells the bond for $1000 and buys $1000 in common stock. Describe the differences in Bob's investment portfolio. (how does it differ; what are the risks; what are his returns)

When the Fed sells bonds to the market, it receives money into its checking account of the banking system. This is expansionary in nature so much so money supply in the economy will increase.

To answer this question we need to know the statutory reseve ratio demanded by the Fed from Banks. This figure is not provided in the question. If we assume that the reserve ratio is 0(zero) then it would result in an infinite multiplier effect on the money supply.

The act of giving credit./debt by the banking system is always expansionary. Debtt actually pumps money into the economy. This will boost aggregate demand in the economy, and Bob is likely to increase his spending pattern.

Bond gives a fixed income return to Bob. Stock returns are uncertain.

Bobs portfolio has become riskier . But higher the risk, the higher the probability of loss and returns. Risk and returns are inversely related .

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