Question: 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: 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: 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.
Question: What is yield-curve represent?
Answer: Yield-curve, represent the relationship among interest rates or yield on the bonds over different maturities.