The central bank’s purchase of gov debt lower the interest rate? 1. Demand for bonds rises → bond prices increase. 2. Because of that inverse relationship → yields (interest rates) fall.
Why does the central bank’s purchase of gov debt lower the interest rate?
ChatGPT said:
Excellent question — and this goes to the heart of monetary policy and bond market dynamics. Let’s unpack it clearly and step by step.
🧩 1. Basic relationship: Bond prices vs. interest rates
Government bonds (like U.S. Treasuries or Japanese JGBs) have an inverse relationship between their price and yield (interest rate).
When bond prices go up, yields (interest rates) go down.
When bond prices go down, yields go up.
Why? Because the coupon (fixed interest payment) is set when the bond is issued — so if the price changes later, the effective return (yield) changes inversely.
Example:
A ¥100 bond pays ¥2 interest each year → yield = 2%.
If its price rises to ¥110, yield = ¥2 / ¥110 ≈ 1.8%.
If price falls to ¥90, yield = ¥2 / ¥90 ≈ 2.2%.
🏦 2. What happens when the central bank buys government debt
When a central bank (like the Bank of Japan or Federal Reserve) buys government bonds on the open market, here’s what occurs:
Demand for bonds rises → bond prices increase.
Because of that inverse relationship → yields (interest rates) fall.
This reduces borrowing costs for the government and, indirectly, for the whole economy (since other interest rates often follow government yields).
💰 3. Mechanically (Open Market Operations)
This is a classic monetary policy tool:
The central bank creates money (electronically) to buy bonds from banks or investors.
The sellers (banks, funds, etc.) receive new reserves (cash).
With more cash and fewer bonds, banks have excess liquidity → short-term interest rates fall.
Long-term yields also drop because bond prices rise due to the purchases.
📉 4. Broader economic effects
Lower interest rates → cheaper loans for businesses and households.
Higher asset prices (bonds, stocks, real estate) → wealth effect.
Weaker currency (sometimes), as investors seek higher yields abroad.
All of this is intended to stimulate growth and inflation when the economy is sluggish.
🧠 Summary
| Step | Effect |
|---|---|
| Central bank buys government bonds | Increases demand for bonds |
| Bond prices rise | Yields (interest rates) fall |
| Lower yields spread across financial system | Borrowing becomes cheaper |
| Economic stimulus | Spending and investment encouraged |
If you’d like, I can also show why this still works even when rates are near zero (as in Japan or the U.S. post-2020) — i.e., quantitative easing (QE) effects. Would you like me to explain that part too?
Comments
Post a Comment