Question-16: How does interest rates are affected?

Answer: In general, this is affected based on the supply and availability of credit. Usually, credit is made available by the domestic household. If a household is producing more and consuming less. Hence, credit is created by him. Means whatever is additional would be borrowed by some borrower and in future it would pay it back with the interest. So if more is available for credit, borrower can get it at lower interest rates.

Question-17: What is the central bank in United states?

Answer: In United states Federal Reserve is known as Central Bank.

Question-18: Why it is said that central bank has monopoly on liquidity creation?

Answer: Because it gives the central bank the ability to set interest rates for short-term which affect the transactions in the economy and helps in increasing the liquidity.

Question-19: What happens when Central Bank enters the market and purchase government securities from bond dealers?

Answer: Lets see step by step (This is happening when economy is weak and unemployment rates are high)

• Central Bank enters the market and purchase the government securities from the bond dealers using the dollars or money which they have in their own reserve.
• In turn liquidity increases in the financial markets.
• Now money received by the dealer, he would either buy another bond or deposit these dollars to the banks.
• Now bank would have more dollars.
• Usually, bank does not hoard this cash and this dollar would go into the interbank market.
• The interbank rate, which is federal funds rate, declines.
• Hence, purchases of bonds by a central bank add liquidity or more dollars in the financial market.
• Now Central bank’s balance sheet is expanded: bonds are on asset side, and dollars, on the liability side.
• So, liquidity injected by the central bank in the financial market.
• Which reduces the interest rates in turn, and reduces the borrowing cost for individual as well as for businesses.
• As result they would do more expenditure. Which helps in increasing the GDP.
• At the same time CD’s (Certificate of Deposit) rates would also reduces and bring down the money market interest rates as well.
• Now investor who has money looking for higher interest rates.
• As interest rates is down, investor is ready to take more credit risk to get more return.

Question-20: What happens when Central Bank enters the market and sell government securities to bond dealers?

Answer: This usually happens when economy is growing above its potential GDP and chances of inflation are very high and they want interest rate should go high.

• Fed (Central Bank) would sell assents from their portfolio.
• The financial system would have less liquidity (Because Fed would fetch money from the Financial Market)
• Which causes the interbank rate to go up.
• And money market and then long-term rates rises.
• It reduces the overall spending capacity by the sectors which are sensitive to interest rates.