Jan 10, Countries attempt to balance interest rates and inflation, but the supply, inflation may ensue, which is not necessarily a bad outcome. But low. Inflation is a rise in the general price level of goods and services. What is the relationship between interest rates, inflation, and exchange rates in an economy? .. They have different objectives, and different meanings to the word "goods. In this lecture we will learn how exchange rates accommodate equilibrium in financial markets. For this purpose we examine the relationship between interest.
The fourth equation says that the domestic real interest rate must exceed the foreign real interest rate by the risk premium minus the expected rate of increase in the real exchange ratean increase in the expected real exchange rate creates an expected capital gain from holding domestic rather than foreign real capital goods, making it profitable to hold them at a lower real interest rate.
The latter could be brought about by reducing the money supply under circumstances where domestic residents know that the resulting appreciation of the real exchange rate is a temporary overshooting adjustment that will subsequently dissipate.
These conditions give the small country's central bank little room to manipulate the domestic real interest rate. It is quite easy for the domestic central bank to manipulate the nominal interest rate. By changing the rate of expansion of the domestic money supply it can ultimately change the domestic rate of inflation.
As soon as the new rate of inflation becomes anticipated the domestic nominal interest rate will adjust accordingly. Although changes in the real interest rate, if perceived to be permanent, are likely to affect domestic investment, nominal interest rate changes by themselves have no effects on investment, output and employment.
The above conclusions seem to conflict with the assertions of most central banks that they conduct their monetary policy by manipulating domestic interest rates.
On closer examination of these claims, however, it is apparent that the interest rates central banks claim to control are the interest rates on overnight loans of reserves between commercial banks and not the real interest rates that enter into the determination of investment expenditure. As banks clear cheques drawn on each other, reserves are constantly shifting from bank to bank.
Since these reserve holdings bear minimal interest, banks will choose to keep them as small as is consistent with their obligations to their depositors and any government regulations that apply. When a bank's reserves are drawn down unexpectedly it will borrow reserves on an overnight basis from other banks who have a surplus over their needs.
When all banks find themselves short of reserves the interest rate on these overnight borrowings will increase and when they have surplus reserves the overnight rate will decline. These interest rates on overnight borrowing will never diverge persistently from the interest rates on the broad range of other assets in the economy because, given a few days or a week, banks can always liquidate their assets to replenish reserves or shift excess reserves into a broad range of assets.
And the domestic interest rates at which banks can lend and borrow in the economy as a whole are anchored to foreign interest rates on securities of equivalent risk and maturity. In many cases a central bank, by increasing and decreasing the reserves of the banking system, can substantially move the overnight rate on inter-bank loans, but the effect is necessary temporary since the banks can access the broader capital market within a day or two.
Every time the central bank expands reserves, of course, it increases the money supply and every time it contracts reserves the domestic money supply declines. Central banks usually also set an interest rate at which they will lend as a "last resort" to commercial banks that are short of reserves. This interest rate, called bank rate, is usually announced in advance along with a target level or range at which the central bank would like to keep the overnight interbank borrowing rate.
While the central bank may exercise the intention of moving the overnight borrowing rate up or down it can never be sure that it has accomplished its goal, since this rate is also affected by market conditions which central bank economists can only forecast imperfectly. The bank thus will often not be able to determine whether it was responsible for moving the overnight rate in a particular direction or whether the rate would have moved in that direction anyway.
One way a central bank can maintain pinpoint control over the rate of interest on overnight borrowing of reserves is to make deposits with it the entire source of such reserves and to pay interest on those deposits at rates that will maintain its position as the sole source of overnight reserves. As long as it is set high enough, this interest rate comes under the direct control of the central bank, and will be correlated with market rates only to the extent that the authorities manipulate it to be so correlated.
Nevertheless, the home truth is that everytime most central banks try to manipulate their overnight rate they change the money supply in a direction that can be predicted from its declared intentions.
And, to the extent that they control the overnight rate directly, they can change the stock of reserves without affecting it. By changing the official level or range for the overnight rate, a central bank can inform the private sector of its policy intentions, whether or not its subsequent actions actually significantly affect the rate. Such announcement affects will affect market expectations. Changes in bank rate perform the same function, whether or not the central bank actually loans a significant quantity of reserves to the banking system at that rate.
Figure 1 plots the Canadian year-over-year inflation rate together with the interest rates on Canadian treasury bills and day commercial paper and the interest rate on overnight borrowing of reserves by the banking system.
The latter rate is essentially set by the Bank of Canada. A similar plot for the United Kindom, presented in Figure 2, presents the inflation rate along with the interest rate on U. Figure 3 plots the U. As is quite evident from the above plots, there is a strong positive relationship between each country's year-over-year inflation rate and its interest rates.
Indeed the coefficients of correlation of the treasury bill rates and the year-over-year inflation rates are.
Of course, we would expect the correlations between the interest rates and the expected inflation rates, which are unobservable, to be much higher than those between the interest rates and the actual inflation rates. The differences between the interest rates plotted for each country are quite small. Figures 4, 5 and 6 below plot, for the past 8 years, the interest rates that the authorities of the respective countries claim to control along with the day commercial paper rate in the case of the United States, the day commercial paper and treasury bill rates for Canada and the treasury bill rate in the case of the United Kingdom.
Note that the Canadian commercial paper rate tends to be above that country's treasury bill rate as is consistent with the fact that corporate paper tends to be more risky than treasury bills. The interest rate on overnight borrowings of reserves, which the Bank of Canada controls, tends to be below the treasury bill rate when the latter is rising and above the treasury bill rate when that rate is falling. This would be consistent with a process whereby the Bank of Canada adjusts the overnight rate to keep it in line with market conditions rather than use of the borrowing rate to induce changes in other market rates.
Indeed, given the existence of an international market for Canadian treasury bills, it is difficult to imagine how world asset holders would change their evaluation of those securities based on the interest rate on overnight borrowing of bank reserves.
The only possibility would be that the Bank of Canada's adjustment of the borrowing rate would change world asset holders expectations about future Canadian inflation. There is no basis for arguing that the underlying real interest rates relevant for domestic capital investment will be affected by Bank of Canada manipulation of the overnight borrowing rate, even if that happens to involve changes in the Canadian money supply.
Monetary Policy, Interest Rates and the Exchange Rate
Money supply changes would be expected to lead instead to overshooting movements in the Canadian nominal and real exchange rates, implying that the Canadian authorities should use the effects on the nominal exchange rate as a measure of the degree of expansiveness of their monetary policyit is the effect on the real exchange rate that leads to changes in aggregate demand. In the United Kingdom the official bank rate, which the Bank of England controls, also tends to be below the treasury bill rate when the latter is rising and above it when it is falling, as is consistent with the possibility that the authorities adjust bank rate in response to changes in market interest rates.
Changes in other variables can also affect the domestic exchange rate. Initially, the increase in the foreign interest rate leads to an increase in the expected return on foreign assets above the return on domestic assets a shift to the right of the curve representing the expected return on foreign assets.
This, in turn leads domestic investors to dump domestic assets and currency; this capital outflow causes an immediate depreciation of the domestic currency. In the new equilibrium the domestic currency depreciates by a percentage amount equal to the increase in the foreign interest rate, i. This effect of a higher foreign interest rate is represented graphically in Figure Effect of Economic Shocks on the Exchange Rate Under Fixed Exchange Rate Regimes As discussed above, under a regime of flexible exchange rates economic shocks such as a change in foreign interest rates or an exogenous change in expectations about future exchange rates lead to a devaluation of the domestic currency.
What will be the effect of such shocks in a regime of fixed exchange rates? In the discussion above on fixed exchange rates we argued that, in a regime of fixed exchange rates, the central bank has no autonomous power to arbitrarily change the level of the money supply. That, however, does not mean that the domestic money supply is always constant under fixed rates. In fact, shocks to the variables that determine the demand for money i.
The equilibrium in the money market under fixed rates is given by: The domestic interest rate will also increase and this will lead to a reduction of money demand. To restore the equilibrium the money supply must also fall. How will this reduction of the money supply be achieved?
When the foreign interest rate goes up, the domestic interest rate is initially unchanged: In order to prevent the currency depreciation that this capital outflow would cause under flex rates, the central bank intervenes and sells foreign currency. In turn, this intervention reduces the money supply and leads to an increase in the domestic interest rate up to the new higher world interest rate.
At that point, the loss of reserves stops, the money supply is lower than before as the forex intervention took domestic liquidity out of circulation and the domestic interest rate has risen to the level of the world interest rates.
Alternatively, the central bank could achieve the same reduction in the equilibrium level of the money supply necessary to restore the equilibrium in the money market via an open market sale of domestic government bonds rather than the above sale of foreign reserves.
Both actions lead to the same required result: In this example, open market operations are effective in changing the money supply but this does not mean that the monetary authority had any autonomous power to change the money supply. Quite to the contrary, the initial increase in the world interest rate forces the central bank to engineer an equilibrium reduction in the domestic money supply: In this example, open market operations do affect the money supply under fixed rates but not because the central bank has an autonomous power to change the money supply: The effects of the increase in the foreign interest rate under fixed rates are presented graphically in Figure This increase in the domestic interest rate is obtained by an endogenous reduction in the domestic money supply from MS1 to MS2.
How will this contraction in the money supply occur? Either the central bank intervenes to defend the currency when the foreign interest rate goes up and this intervention leads to a fall in the money supply; or, equivalently, the central bank performs an open market sale of government bonds that reduces the liquidity in the economy.
Both actions have the effect of reducing the domestic money supply and increase the domestic interest rate to the higher world interest rate. Another shock that might occur in a regime of fixed exchange rates is a change in expectations that leads to an expected future depreciation of a fixed exchange rate.
How should monetary authorities that are trying to defend a fixed parity react to a change in investors' sentiments about the credibility of the country commitment to fixed exchange rates?
To understand this case, one must first note that, under fixed exchange rates, the exchange rate parity is constant. So, in normal times when the commitment to a fixed parity is credible the future exchange rate is expected to remain equal to the current fixed parity as agents believe that the parity will not be changed.
However, being in a regime of fixed exchange rates does not mean that the fixed parity will never be changed. For example, if the central bank runs out of reserves to defend the currency, a devaluation might occur at some point. This means that a fixed parity may not be fully credible in the sense that there is a positive probability that the future exchange rate will be different from the current one if a devaluation occurs. In other terms, in spite of the current fixity of the exchange rate, changes in the expectations about the future value of the exchange rate might occur even in a regime of fixed exchange rates that is not fully credible.
Such changes in expectations may be due to good reasons such as changes in fundamental variables high domestic inflation, large budget deficits, political risks and so on or might, at times, also be caused by "irrational" changes in the investors' sentiments. Self-fulfilling changes in expectations may lead investors to believe that a fixed parity will collapse and this will lead them to a speculative attack on a currency that has a fixed parity, even if there has been no change in the underlying fundamental determinants of exchange rates.
Then, the question to be addressed is the following: Given this change in expectations, what can a central bank do to prevent the devaluation of the exchange rate from occurring? The answer to this question is simple: To see how an expected depreciation of the domestic currency must lead to higher interest rates in a regime of fixed rate consider Figure Suppose that, for whatever reason, there is a shock that leads investors to expect that the domestic exchange rate will depreciate in the future.
Assume that, before this shock, the fixed rate regime was fully credible and agents were not expecting any depreciation of the exchange rate in the future, i. For example, assume that both actual and expected exchange rates were equal to 1. The effect of this change in expectations is presented in Figure The shock to expectations shifts to the right the curve representing the overall return on foreign bonds: As discussed in a previous section, if the economy was in a regime of flexible exchange rates, the change in expectations about the future exchange rate from 1 to 1.
In a regime of fixed exchange rates, instead, such a devaluation of the currency must be prevented. In fact, given the shock to expectations, domestic residents will not try to dump the domestic assets and currency in favor of the foreign assets only as long as the domestic assets provide a return equal to the expected return on foreign assets.
As the figure shows, the increase in the domestic interest rate is achieved through an endogenous reduction in the domestic money supply from MS1 to MS2. As in the case discussed before of an increase in the foreign interest rate, the reduction in the domestic money supply can be achieved in two equivalent ways. Either the central bank intervenes to defend the currency at the time when the change in expectations occurs and this intervention leads to a fall in the money supply; or, equivalently, the central bank performs an open market sale of government bonds that reduces the liquidity in the economy.
Both actions have the effect of reducing the domestic money supply and increase the domestic interest rate. Sterilized and Non-Sterilized Foreign Exchange Rate Intervention Suppose now that the defense of the domestic currency occurs, as it is usually the case, through foreign exchange intervention: Before the intervention the central bank balance sheet was: There is however another type of forex intervention that takes the name of "sterilized intervention".
To understand this type of intervention, suppose that you intervene in the foreign exchange market; such intervention, if it is not sterilized, would lead to a reduction in the money supply and an increase in domestic interest rates as in Figures 14 and Now suppose that, after you intervene, you want to sterilize, i.