Macro-economics

Mar 2017
89
3
Israel
Hello :)

Can you help me please about the next exercise:

A closed economy is in economic equilibrium of full employment.
The central bank bought bonds from public, so the amount of money increased by 1%.
Therefore, the prices will rise by 1% and there will be no change in private consumption and investment.

I didn't understand how the answer is "the prices will rise by 1% and there will be no change in private consumption and investment", because if the central bank bought bonds, in other words, the public took loans, then the interest rates will rise, therefore, the investment will decrease.
But I agree about private consumption.
About the prices, I didn't understand too.

If you didn't understand something, so tell me please and I will try to explain.

Thanks!
 
Feb 2020
15
2
Australia
Gosh this post is nearly 12 months old but I'd still like to offer some insights.
Firstly a key clue to the answer is that the economy is in 'full employment'. This means that the economy is working to full capacity/productivity and any new cash injections will be inflationary because the new money can only be spent on existing fully utilized resources. This drives up prices because demand will now outweigh supply. Consequently consumption does not change only the cost of consumption changes.

So why no change in investment? Consider the sale & redemption of bonds/treasury securities as simply asset swaps rather than 'investment'. When the treasury issues bonds it swaps their paper (asset) for your dollars (asset). Likewise when treasury buy bonds the asset swap is reversed and the bond holder now holds the cash (asset) they had previously forfeited for bonds. Cash held in bonds is not much different from cash held in fixed term commercial bank accounts - only bonds are securer and more liquid. In the real world US Treasury is almost continuously issuing and redeeming treasury securities..


In your post you expressed concern about the impact of bond redemption:
"....if the central bank bought bonds, in other words, the public took loans, then the interest rates will rise, therefore, the investment will decrease."

Firstly you must understand that bond issuance/redemption is a tool of monetary policy. A monetary sovereign country like USA does not need to borrow money to finance its spending. Bond issuance/redemption is to control the official cash rate (% interest charged for interbank borrowing and lending). When treasury issues bonds it drains bank reserves and when it buys bonds back it increases bank reserves. If reserves fall too low it drives up interest rates (see Sept 2019 spike to 10% in overnight cash rate.) This happened because bank reserves got too low. To prevent this from happening treasury will then flood the banks with liquidity to bring interest rates down again. This would have been the effect of the bond buyback in your question. The result would have been a reduction on interbank borrowing interest rates.

To be continued
 
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