Question

4) why does selling bonds by the Treasury to the financial market raise interest rates? (explain briefly)

5) If the central banks buys government bonds from the financial system, how does that affect the interest rates, and what does that mean about the money supply, why, explain briefly?

6) why a central bank be independent from government? (explain briefly)

Answer 1

4. When bonds are sold by the Treasury to the financial market, the agents pay with money for the bonds. There is exchange of money for bonds betwee market and treasury. This decreases money supply in the market. A decrease iin money supply increases competition for lonable funds. This raises price of lonable funds which is the interest rate.

5. If central bank buys government bonds from the financial system, this means that the bank is paying money in exchange for bonds. This will cause money supply to increase in the economy. There will be ease in the competition for lonable funds. This will reduce of cost of borrowing - interest rates.

6. Some reasons why central banks should be independent of the government are -

The main reason is the conflict of interest between the motives of the politicians and the economy. The economy moves according to booms and burst of the business cycle while the politicians are swayed by political decisions which mainly are taken before the elections - the political cycle. If the economy is booming and overheated, there requires a contractionary policy. If this occurs before a election, the politicians wont be inclined towards any contractionary policies before the election as this might put the government in bad light for the layman. To avoid such contradictions it is best that central bank is not controlled by the government.

Another reason is that the main function of central bank(CB) is to control inflation. This requires lessening of government purchases and spending. If CB is under government control, there will again be conflict of interest. Similarly if CB is under government control, the government can use seigniorage for deficit financing of its debts and purchases which can inflate the economy.

Hence it is best for CB to be independent to avoid any conflict of interest.