Suppose the money market has an equilibrium interest rate of 5 percent. If the actual interest rate is 3 percent, which of the following occurs to bring the money market back to equilibrium?
A) People buy bonds, the price of bonds rises and the interest rate rises.
B) People buy bonds, the price of bonds falls and the interest rate rises.
C) People sell bonds, the price of bonds rises and the interest rate rises.
D) People sell bonds, the price of bonds falls and the interest rate rises.

Question

Quizplus · Accepted Answer

When the actual interest rate is below the equilibrium rate, there is an excess demand for bonds because they are priced for higher yields. As people buy bonds, the supply decreases, causing the price of bonds to increase. However, as bond prices increase, their yields (interest rates) decrease, not increase. Therefore, to correct my previous explanation: when the actual interest rate is lower than the equilibrium, people will sell bonds because they anticipate interest rates will rise (to return to equilibrium), which increases the supply of bonds, lowers their price, and as a result, the interest rate rises. This aligns with the basic principles of supply and demand in the bond market. The correct dynamic is that when people sell bonds, the price of bonds falls, and as bond prices fall, the yields (or interest rates) on those bonds rise, moving the market back towards the equilibrium interest rate.

Suppose the Money Market Has an Equilibrium Interest Rate of 5