3 April 2020

Increasing short-term interest rates -Transmission discussion

  • Money market
  • Longer bond market
  • Wider borrowing rates
  • Common stock prices
  • Exchange rates

Money market – Theoretical approach

  • Central bank sells short-term bonds
  • Leads to higher supply
  • Leads to decreased prices
  • Therefore, interest rate level has to increase
    • According to PV Formula:
      PV = \(\frac{CF}{1+i}\)

Figure 1: Central bank sells of short-term bonds shifts supply curve

Figure 1: Central bank sells of short-term bonds shifts supply curve

Money market – Practical approach

  • Central bank sells short-term bonds
    • Banks must meet reserve requirements (RR)
    • Overnight loans (federal loans) between banks for i
    • i = market rate, federal funds rate
  • Central bank can influence i by carrying out open market operations (OMP)
    • Central bank sells short-term bonds -> bond supply shifts (figure 1)
    • Banks buy bonds
      • Reserve requirements
      • Demand for federal loans increases
      • Subsequently i increases
        (lending banks can require higher interest rates)

Longer bond market

  • Expectations theory: \(i_{nt} = \frac{i_{t}+i_{t+1}^e+...+i_{t+n-1}^e}{n}\)
  • Liquidity premium and preferred habitat theories add a premium to the formula
  • Channel 1: arbitrage, reduce of \(i_{t}\) reduces \(i_{nt}\)
  • Channel 2: expectations may be altered:
    • reducing \(i_{t}\) reduces also \(i_{t+1}, i_{t+2},...\)
    • resulting with decreased \(i_{nt}\)
  • Strong correlation between interest rates of different maturites (figure 2)

Figure 2: Similar interest rate development of bonds with different maturities

Figure 2: Similar interest rate development of bonds with different maturities

Wider borrowing rates

  • Marketable debt:
    • Riskier bonds result in higher bond rates
      (if maturity is the same)
  • Non-marketable debt:
    • Competition in banking sector
    • Interest rates depend on banks borrowing costs (short-term interbank i)
    • Then, banks adapt clients interest rates
      • Examples:
        • Mortgages
        • Business loans
        • Deposits
      • However, there is also a risk spread which varies over time

Figure 3: Similar interest rate development of different borrowing types

Figure 3: Similar interest rate development of different borrowing types

Common stock prices

  • Payoff-delivering asset
  • Dividend valuation model:
    \(P_{0} = \frac{D_{1}}{(1+k_{e})^1}+\frac{D_{2}}{(1+k_{e})^2}+\frac{D_{3}}{(1+k_{e})^3}+...+\frac{D_{n}}{(1+k_{e})^n}+\frac{P_{n}}{(1+k_{e})^n}\)
  • Special case of the Gordon growth model:
    \(P_{0} = \frac{D_{1}}{(k_{e}-g)}\)
  • \(k_{e} = i + rp_{e}\)
  • Expected dividend growth (g) goes down if i increases
    (creates an economic decline)
  • Pricing effects:
    If i increases, \(k_{e}\) increases aswell
    If g decreases, \(P_{0}\) decreases aswell

Exchange rate

  • Increase in domestic interest rate shifts the demand curve to the right
    (More international capital flows into domestic market, figure 4)
  • Exchange rate increases (appreciation)
  • Exports increase
  • Imports decrease

Figure 4: An increase in the interest rate

Figure 4: An increase in the interest rate

Thank you for your attention!