The private sector wants more financial assets, and bond sales or purchases do not do this. When the government buys a bond from a willing seller, that seller plans to roll the proceeds of the sale over into some other investment.

Alternately, a household may decide to draw down their stock of financial assets and spend more, or spend less and increase their stock of financial assets. But neither of these decisions is affected in any meaningful way by government OMO.

Deposits do not compete with bonds as an asset class.

Deposits are for immediate transactional needs as well as a fall-back buffer stock — much like inventory management in the business world. You have some inventory in the store, and more in the warehouse — this is called “working” capital. No one expects working capital to earn a return, and working capital does not compete with long term assets. There is no trade-off between the two.

In the same way, you should be careful when valuing “walking around” cash, checking accounts, and savings accounts as financial assets. The benefit of holding deposits is utility, not return. The choice is not money in your checking account vs. buying an MBS. The choice is between consumption and investment, and then you set the deposit account levels based on your transactional needs.

As a result, you only buy a bond if you first sell some other investment. It does not come out of a reduction in your walking around money. And neither does a bond sale result in an increase in your walking around money.

You may decide to invest less or more overall, but those are separate decisions from the instrument used. The instrument trades at the level of indifference, and no purchase or sale benefits anyone in a predictable way, or cause anyone’s deposit account levels to increase or decrease.

(“Other things equal” means the yield curve progresses over time such that the value of the security reverts to par immediately following each coupon payment. That just means that market yields follow the original implied forward yield curve of a bond originally priced at par.)

The cycle repeats over each period between coupon payments. When the bond matures, the holder has his original principal plus the accumulated portfolio from cash coupons, however that has been invested.

During the life of the bond, the marked to market effect of other yield curve changes is additional valuation noise that is overlaid on the basic interest accrual, payment pattern, and portfolio result of owning a bond. If the bond is held to maturity, that noise ends up being of no significance to the final value of the portfolio, other than its effect on the reinvestment of coupons.

(I recommend the classic “Inside the Yield Book” by Homer and Leibowitz.)

http://www.amazon.ca/Inside-Yield-Book-Classic-Analysis/dp/1576601595

So, according to this, if I spend $100 on a $100 face value bond with a 10% coupon, after 1 year, I will get $10 in interest and the market value of the bond will drop to $90, after year 2, I will get another $10 interest and the market value of the bond will drop to $80, etc…

In year 11, the market value of the bond will be negative.

Increasing monetary base increases private sector stock of cash, but as you say, this is going to banks and not households.

Increasing bank’s holding of monetary base has no impact on AD.

a. fed rate decreased
b. market supply decreased while demand increased

and b is the point which you and I try to argue about.

So when the previous term deposit contract of households expires they enter into a new one at much lower rate and they accept it as it is. Do they lose income due to (b)? Yes, they definitely do because they have to pay higher prices or lock in lower coupons

Market efficiency or fed purchases’ efficiency is not the issue here

When the Treasury borrows in the markets, offers tsys in return and spends the cash it has borrowed, this increases private sector net financial assets and in the form of an expanded holding of tsys. But the latter are not liquid from the point of view of the private sector as a whole. Also, to the extent that this operation is stymied by crowding out, there is no increase in aggregate demand.

Then when the Fed prints more monetary base and buys the tsys, those illiquid tsys become liquid. I don’t how much extra AD one gets from the process in the above para (and I suspect few other people are sure). But when the process is completed by the Fed buying the tsys, the private sector’s stock of cash rises and an increase in AD is much more likely.

2) Over time, the market value of the bond increases by the discount rate of the bond, but not in NPV terms.

3) On the “ex-coupon” date, the amount of the coupon is subtracted from the market value of the bond

4) You cannot make money by buying a bond the day before a coupon is paid, and selling the bond the day after the coupon is paid. The bond will sell for the previous price net of the coupon paid.

5) Therefore the portfolio of the bondholder does not increase or decrease in value when the coupon is paid. It increases or decreases in value based on the overall discount rate for the economy, which represents the opportunity cost of investing in the universe not containing the bond — i.e. the next best investment. So the return of MBS is determined by everything OTHER than MBS, and the return of government securities is set by the return of non-government securities. The price of any asset is set by the cost of replicating that return in the universe not containing the asset.

6) Therefore if the government buys the bond from a willing seller at market prices, you can assume that the seller believes that he has a “next best” investment that will give the same return. If he did not believe this, he would not sell the bond, or would demand more money for the bond.

Putting all of those things together, the payment or not payment of coupons does not cause the portfolio of the investor to increase in value — it is the overall opportunity cost as measured by the discount rate that causes the portfolio to increase in value, and this rate is unchanged even if all the bonds are purchased by the CB in an OMO.