Suppose that the bond market and the money market both start out in equilibrium, then the Federal Reserve increases the money supply. The result will be a in the money market and a in the bond market, which will push bond prices and interest rates will until a new equilibrium is reached.

a) shortage; surplus; down; fall
b) surplus; shortage; up; fall
c) shortage; surplus; down; rise
d) surplus; shortage; down; rise

b) surplus; shortage; up; fall

Explanation:

If the bond market and money market start out at equillibrum, and money supply is increased there will be an excess (surplus) of money over bonds.

That is more money to buy less bonds. The relative scarcity of bonds will result in a shortage (bond supply cannot meet demand).

As a result of the shortage price of bonds will increase because more people are looking for the scarce bonds.

Price of bonds has an inverse relationship with interest. As price increases interest rates will fall.

For example consider a zero coupon bond of $1,000, being sold for low price of $850. On maturity it will yield gain of $150.

If the price rises to $950 the yield will only be $50.

So as price increases and interest (yield) decreases, it will no more be attractive to investors and demand will reduce to meet the available supply of bonds.

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