In this chapter we continue to review disturbances and policies, using the diagrams developed in Chapter 4. We start with disturbances and policy changes that impinge directly only on the asset markets, then turn to those that have direct effects on both goods and asset markets.

Asset-market disturbances

It would be quite easy to define shifts in demands for assets analogous to the shifts in demands for goods analyzed in Chapter 4. We could ask what would happen, for example, if households sought to hold more foreign bonds and fewer domestic bonds. The consequences of such shifts, however, are captured by the two asset-market disturbances defined in Chapter 3. When the central bank purchases domestic bonds in the open market, it raises the total demand for those bonds and the supply of money. The effects resemble those that would occur if households sought to hold more bonds and less money. Similarly, an increase in the foreign interest rate raises the demand for the foreign bond and reduces the demand for the domestic bond. The effects resemble those that would occur with a shift in demand from domestic to foreign bonds. It will therefore suffice to analyze these two examples.

Open-market operations

As there are no commercial banks in this model, the central bank can alter the money supply only by altering its own assets. Open-market operations are the only instrument of monetary policy, and we shall examine them in some detail.