Monetary policy is one of the economic tools used by various governments to control a country’s economic growth. According to Madura (2008, p.46), monetary policies are formulated and implemented by the Central Bank. Through the monetary policies, the government is able to control the amount of money circulating in the economy. By incorporating monetary policies, the government is able to attain macro-economic stability such as low rate of inflation, balance in the country’s external payments, low rate of unemployment and high economic growth.
According to Russel (2008), monetary policy is one of the factors which affect the interest rate. Through the Federal Reserve, the US government is able to control interest rate by formulating effective monetary policies. Monetary policies are categorized into contractionary and expansionary policies. Contractionary monetary policies involve controlling money supply by reducing the amount of money circulating in the economy. On the other hand, expansionary monetary policy entails increasing the amount of money circulating in the economy. There are three main instruments which are utilized in the process of implementing monetary policy. These include;
- Reserve requirement
- Discount window
- Open market operation
According to Russel (2008), discount window entails the rate at which commercial banks can borrow money from the Central Bank. The rate is usually set below the existing short-term market interest rate. As a result, commercial banks are able to increase their lending capacity by lowering their interest rate. The resultant effect is an increment in the amount of money circulating in the economy.
Commercial banks are also required to open an account with the Central Bank. In this account, commercial banks should deposit and maintain a certain amount which is determined by the Central Bank. This means that commercial banks only reserve a small proportion of their total assets in form of cash. The resultant effect is reduction in the commercial bank’s lending capacity. Reduction in lending capacity leads the commercial banks to increase the interest rate. As a result, the Central Bank is able to control interest rate. As one of the monetary policies, open market operation involves the process through which the Central Bank issues government bonds to individual and institutional investors.
According to Pirayoff (2004, p.79), an indirect relationship exists between money demand and interest rate. Increasing money supply through adoption of an expansionary monetary policy, leads into a decline in nominal interest rate. Nominal interest refers to the opportunity cost associated with holding money compared to holding an asset which can bear interest. From the graph below, it is evident that an increase in money supply from MS0 to MS1 leads into a decline in interest rate from i0r to i1r . If money supply is reduced from MS1 to MS0, the rate of interest would rise from i1r to i0r.
From the above analysis, it is evident that the Federal Reserve is responsible for the existing interest rate through the above methods.
Fiscal policy entails influencing a country’s economic activity through increasing or decreasing government expenditure. There are two main methods used by governments to finance their expenditure. These include borrowing and taxation. The fiscal policy is also categorized into two. That is;
- Expansionary monetary policy
- Contractionary monetary policy
An expansionary fiscal policy entails the government increasing spending more than its tax revenue while contractionary fiscal policy entails government spending which is less than the total tax revenue. Expansionary fiscal policy leads to a rise in the interest rate.
On the other hand, contractionary fiscal policy leads to a decline in the rate of interest. The effect of fiscal policy on the interest rate is illustrated by the IS-LM model. Output in the goods market is illustrated by the formula Y=C+I+G+M where Y=Gross Domestic Product (GDP), C=Consumption, I=Investment and M=Net exports. On the other hand, the money market is illustrated by the LM curve. An expansionary fiscal policy involving an increase in government debt as a result of increase in government spending leads into an outward shift in the IS curve from IS1 to IS2. This arises from the fact that an increase in government spending leads to an increase in output (Gross Domestic Product) from Y1 to Y2 leading to an increase in price. According to Arnold (2007), the theory of money demand asserts that an increase in price of goods and services leads to an increase in demand for money (transaction demand).
As a result, individuals prefer holding investment portfolio consisting of more money. The resultant effect is a decline in demand for securities such as bonds. Considering the fact that money supply is constant, the interest rate increases from i1 to i2 as illustrated in the graph below. Similarly, a reduction in the volume of output leads to a decline in prices. As a result, individuals prefer holding securities and less money. This culminates into an increment in the price of securities which is similar to a decline in interest rates.
With regard to demand for money, a decline in price for goods and services leads to reduction in demand for money. Considering the fact that money supply is constant, the resultant effect is a decline in the interest rate. The relationship between fiscal policy and interest rate is illustrated by the graph below.
Supply and demand
According to Arnold (2007, p. 348), interaction of the market forces play a significant role in determining of the nominal rate of interest. This means that the interest rates depict the flow of money between the surplus and the deficit units, that is, between lenders and borrowers. Through the rate of interest, a balance is established between the demand and supply units. Variation in the amount of money available affects other macro economic variables such as the rate of consumption, investment hence the gross domestic product. According to Brigham and Houston (2009, p.165), the interest rate is determined by interaction of market forces. Consider two capital markets, Market A and Market B. The supply curve in the two markets is upward sloping which depicts the investor’s willingness to increase capital supply at a higher rate of interest. This arises from the fact that they will receive a higher return from their investment. On the other hand, demand for money is downward sloping which depicts that individuals are willing to borrow more money at a low rate of interest. The prevailing interest rate is depicted by interaction of the demand and supply curves. From the illustration below, the prevailing equilibrium rate of interest in the low-risk securities markets A is 6%. This means that individuals can obtain a loan at a cost of 6% while investors can obtain a return of 6%. On the other hand, risk taking investors can obtain a return of 8% similar to the cost incurred by risk taking borrowers. This means that investors are willing to incur a risk premium of 2% (8%-6%) in order to attain a higher return.
Due to changes in forces of demand and supply, investors in market B develop a perception that market is more risky. Considering the fact that investors are risk averse in their investment, a large number of investors consider shifting to market A which is less risky markets. The shift culminates into an increment in the amount of money supply in market A to S2 from S1. Due to increase in the amount of capital available in the market, the rate of interest decreases from 6% to 5% considering the existence of an inverse relationship between money supply and interest rates. The investors shift from market B to market A results into a decline in money supply culminating into a tight credit market. This forces the rate of interest to increase from 5% to 8%. The shift leads to transfer of money from market B to A. This culminates into an increment in risk premium with a margin of 3%.
Rate of inflation
Demand and supply for capital is also influenced by individual’s expectations regarding the rate of inflation (Arnold, 2007, p.348). Consider an economy with 8% as the prevailing rate of interest and an inflation rate of 0%. If the rate of inflation increases with a margin of 4%, the borrowers are willing to pay an addition 4% to obtain funds and purchase the goods and services at the current price. Alternatively, the borrowers can wait for some time and pay an additional 4% in the prices of goods and services. This means that the expected rate of inflation leads to an increase in demand for money. This culminates into an increment in the rate of interest.
On the supply side, the expected rate of inflation makes the suppliers of fund to increase the rate of interest with a margin of 4%. The increment is aimed at compensating for the effects of inflation. This means that the lending rate will increase to 12%. The expected rate of inflation leads to an increase in demand for financial capital and a decline in the supply for money. In addition, the rate of interest (nominal rate) increases with the same margin. From the graphical illustration below, the 8% represents the real rate of inflation which is computed using the formula;
Real interest rate= Nominal rate of interest- expected rate of inflation
= [8%= 12%-4%].
In their borrowing decisions, both the lenders and the borrowers consider real interest rate rather than the nominal rate.
According to Madura (2008, p.24), demand for capital (loan) to cater for housing expenditures varies from one household to another. Financing household expenditure using debt leads to into debt. Madura asserts that there is an indirect relationship between demand for loanable funds and the rate of interest. This means that a decline in the rate of interest leads to an increment in demand for loan capital. Household borrowing can be affected by factors such as the tax rate. For example, if income tax is expected to decline, households increase their demand for loans since they consider that they will be able to repay in the future. This leads to a decline in the rate of interest.
Technical and fundamental analysis
According to technical analysis, the rate of interest is influenced by investors’ behavior. Technical analysis asserts that securities portray a particular trend which is repetitive in nature. This means that the same trend will be portrayed in the future. Due to fluctuation of the interest rate, the movement forms a trend composed of the head and the shoulder. The head represents the highest point or the peak of the trend while the shoulder is depicted by the lowest point. Through technical analysis, it is possible for an investor to forecast the interest rate based on historical movements hence making optimal investment decisions. From the graph below, the peaks (head) are represented by an interest rate of 9.5% which occurs in 2000 and 8.25% which occurs in 2006. On the other hand, the lowest point identified in the trend occurs in 2002 at 4% and in 2009 at 3.25%. The period between the highest point to another and the lowest point to another is 7 years. Therefore, there is a high probability that another peak will occur after a period of seven years, that is, in 2014. Considering the repetitive nature of the movement in the rate of interest rate, there is a high chance that the interest rate will be approximately 9% similar to the previous rate experienced in 2000.
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On the other hand, fundamental analysis involves taking into consideration the current market trends. This can be attained by evaluating the firm’s trading history such as its securities price history. Fundamental analysis asserts that securities may be mispriced in the short run. However, due to economic changes, the correct price of the securities will be attained in the long term. This means that the market reflects all the existing market fundamentals. For example, a company’s security may be trading at $ 20. After a comprehensive analysis of the firm’s history, it is established that the security’s true value is $25. $25 represents the security’s intrinsic value. The price of $20 will make a large number of investors to purchase the security. This arises from the fact that investors prefer investing at a price lower than the intrinsic value.
How Fisher Effect Equation can be used to forecast interest rate, exchange rate and inflation rate
The fisher equation is used to express the nominal rate of interest by taking into account the expected rate of inflation and real interest rate. Fisher equation gives a close approximation of the rate of interest. For example, consider the real rate denoted by A to be 1.25% while expected inflation denoted by I 4%. Using the fisher equation represented by the formula 1+R = (1 + A) (1 + I), the nominal rate of interest is 5.30% as illustrated below.
1 + R= (1 +.0125) (1 +.04)
R = 1.0125 x 1.04 – 1= 0.0530=5.30%
If the prevailing real rate of interest between two countries is similar, the fisher equation can be used to approximate the expected rate of inflation by considering nominal rate of interest. In addition, it is possible to forecast the exchange rate by considering the nominal rate using the formula below.
E(S) = S [ ] N
The prevailing rate of exchange between two currencies, the US dollar and Swiss Franc, is 1 Swiss Franc=0.6500 US $.In addition, the annual rate of interest in US 5.3% while that of Swiss is 2.5%. Using the formula above, the expected rate of exchange within a period of one year is US $ 0.6678 for every 1SF as illustrated below.
E(S) = $0.6500/SF1 x [ ] 1 = $0.6678/SF1.
After a period of two years, the expected rate of exchange would be US $ 0.6860 for every 1 SF as illustrated by the computation below.
E(S) = $0.6500/SF1 x [ ] 2 = $0.6860/SF1.
The fisher effect can also be used to forecast the rate of interest. The existing real rate of interest is constant at 5.5% while the rate of inflation rises from 2% to 3%. According to the fisher effect, nominal rate of interest rises to 8.5% from 7.5% as illustrated by the computation below.
Nominal rate of interest=Real rate +Inflation =5.5% +2%=7.5%
New rate of interest = 5.5% +3%=8.5%
Fisher effect and the currency exchange rate
Fisher effect can be used to project movements in a country’s rate of exchange. This arises from the fact that the expected rate of exchange between 2 countries is equal to the differential of the two country’s nominal interest rate. The formula E=i1-i2 is used to determine the exchange rate where E= exchange rate, i1=interest rate for country A, i2=interest rate for country B.
Consider the nominal rate of interest in US to be 5% while that of Germany is 7%. The exchange rate between US and Germany is 2% [7%-5%]. This means that Germany currency will appreciate while that of US will depreciate with a margin of 2%. Currently, the US dollar has a relatively weak exchange rate against the Euro. One of the factors which have contributed to the depreciation is change in the saving rates. As a result of the 2007 financial crisis, US experienced an increment in saving rate from 6% to 10% in 2009. As a result of increment in saving rate, the rate of interest is continually declining. Decline in the rate of interest has culminated into further depreciation of the US dollar against the Euro. As a result of the fisher effect, this trend will persist for some time. However, the US government is committed at keeping the real rate positive.
Interest rate swap
This refers to a contract involving two parties. Each of the parties comes to a consensus to make payments (periodically) to the other for a given duration of time on the basis of an agreed notional principal amount. According to Madura (2008, p. 585), incorporation of interest rate swaps is one of the strategies through which an investor can use to mitigate interest rate risks. Interest rate swap enables an investor swap in fixed rate payments for variable-rate payment. The fixe rate payment is considered to be an outflow whereas the variable rate payment is considered to be an inflow. To mitigate the risk associated with the fixed rate outflow, the investor can match it with fixed-rate mortgages. The resultant effect is that a certain spread is attained. For example, if an investor enters into a contract to make a monthly payment at a fixed rate of 5.32% in on a notional 1 million USD in order to receive a 1 million USD libor monthly for a period of three years, the party who pays and receives the fixed for floating interest is referred to be short.
From the above illustration, it is evident that interest rate swaps entail exchange of cash flows. The fixed-for-floating swap is mainly used to mitigate risk by changing a particular liability from being fixed to floating. For example, an investor has a bank loan of $10 million with a monthly interest rate of 5.3% in addition to an investment of $ 10 million with a floating return of $ 1 million libor plus 25 bps per month. To mitigate risk, the investor may consider incorporating a fixed-for-floating swap. As a result, the investor will be required to make a payment of $1million libor plus 25 bps. In return the investor will receive return at an interest rate of 5.5%. As a result, the investor will lock a profit of 20bps.
From the discussion above, it is evident that the interest rate is affected by both macro economic and micro economic factors. These factors include monetary and fiscal policies which are formulated and implemented by the government through the central bank. Considering the fact that the rate of interest is determined by the interaction of market forces, the government is able to control money supply in the economy through the monetary policies. On the other hand, fiscal policies are to influence the demand for money.
The interest rate is also affected by other economic factors such the rate of inflation. If there is an expectation of the rate of inflation increasing in the future, the current demand for money would increase. This arises from the fact that the rate of inflation will increase the cost of capital in the future. Increase in demand for money culminates into a decline in the rate of interest considering the fact that money supply is held constant. The rate of interest is also affected by household demand for loan.
Using the fisher effect, it is possible for investors to forecast the rate of interest, the exchange rate and also the rate of inflation. This means that investors can be able to make optimal investment decision. Through interest rate swaps, an investor can be able to mitigate interest rate risks.
Arnold, R. (2007). Microeconomics. New York: Cengage Learning.
Brigham, E. & Houston, J. (2009). Fundamentals of financial management. New York: Cengage Learning.
Madura, J. (2008). Financial markets and institutions. New York: Cengage Learning. Pirayoff, R. (2004). Cliffs AP economics micro and macro. New York: John Wiley and Sons.
Russell, M. (2008). Monetary and interest rates. Enzine Articles. Web.