Question

How would the purchase of $8 billion of bonds by the central bank from local banks be likely to affect interest rates? How about the effect on interest rates of the sale of $8 billion worth of bonds? Explain your answers carefully.

Answer 1

Ans 1.)

The Sale and purchase of the bonds by the central bank is referred to as open market operations and is one of the most commonly used monetary policy tool by Central Bank of an economy in order to change the price and output level.

If the government sells bonds and securities to the bank then it is referred to as the contractionary monetary policy as it receives the money in return.

If the government buys bonds and securities from the bank,then it is referred to as the expansionary monetary policy as it gives the money in return.

In an economy,the interest rate is determined by the interaction of money supply and demand curve.

As we can see in the diagram below that when the government buys the bonds, the money supply increases from MS1 to MS2 at a given level of money demand which leads to the rightward shift of the money supply curve and the interest rate in the economy decreases so as to induce the people to hold more money which has been supplied.

Similarly, the other diagram depicts the situation when the government sells the bonds which leads to the leftward shift of the money supply curve as the money supply has decreased in the economy.

When the money supply decreases, the interest rate increases so as to induce people to demand less money and bring the money market at equilibrium.