"Let me now be more specific about the way the bond market works in this economy. I have
assumed that the bond market determines the interest rate on the bonds. In fact, bond markets
typically determine *not* the interest rate but *rather* the price of bonds. The interest rate can then be
inferred from the price. Let us look at the relation between __interest rate__ and __price__ more closely.

Let the bonds be *one-year bonds* that promise payment of** $100** a year hence. In the United
States, such bonds, when issued by the government and promising payment in a year or less, are
called **Treasury bills, **or simply **T-bills. **Thus, you can think of the bonds in our economy as
one-year **T-bills**. Let their price today be** ****$PB***, *where** ** stands** B **for "bond." If you buy the bond today
and hold it for a year, the *rate of return* on holding the bond for a year is equal to **($100 - $PB) / $PB
** (what you get for the bond at the end of the year minus what you pay for the bond today, divided
by the price of the bond today). Thus, the * interest rate (i) *on the bond is defined by

** i = ( $100 - $PB ) / $PB**

For example, if **$PB*** *is equal to **$95**, the *interest rate *is equal to **$5 / $95**, or **5.3 percent**. If *$PB**
*is** $90**, the interest rate is **11.1 percent**. *The higher the price of the bond, the lower the interest
rate.*

Equivalently, if we are given the interest rate, we can infer the price of the bond.
Reorganizing the formula above, the **price**** ($PB)** of a one-year bond is given by

** $PB = $100 / ( 1+ i )**

* *

The price of the bond is equal to the final payment divided by 1 plus the interest rate. Thus, if the
interest rate is positive, the price of the bond is less than the final payment. And the __higher__ the
interest rate, the __lower__ the price today. When newspapers write that "bonds markets went up today,"
they mean that the prices of bonds went up and therefore that interest rates went down.

Let's now look at the effects of an open market operation in which the central bank increases
the supply of money-an expansionary open market operation. In such a transaction, the central bank
buys bonds in the bond market and pays for them by creating money. As it **buys bonds**, the *demand
for bonds goes up* and thus the *price of bonds goes up*. Equivalently, the *interest rate on bonds goes
down*. When, instead, the central bank wants to decrease the supply of money-and thus does a
contractionary open market operation-it **sells bonds**. This leads to a *decrease in their price*, and thus
to an *increase in the interest rate*......."