Chapter 4 Monetary Policy and Interest Rate Determination Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Learning Objectives Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Introduction Interest Rate: It is the price that has to be paid by a borrower of money to a lender of money in return for the use of funds. Term Structure of Interest Rates: The yield to maturity on treasury bills and bonds of different terms to maturity. Money: It is the medium of exchange that facilitates transactions in an economy. Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Bills Bills: They are the financial assets with less than one year until the date that they will be redeemed by the original borrower. They have a highly liquid secondary market They are highly attractive assets as they have negligible risk and high liquidity. They are sold at a discount ton their face value. Holders of bills benefit entirely from capital appreciation. Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Bills Example: If a three month $100 bill is sold at $97, the annual rate of interest at the time of issue is: Example: If a three-month $100 bill is sold at $98, the annual rate of interest at the time of the issue is: Inverse relationship between the price of the bills and the short-term of interest rate. Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Bonds They are longer term financial assets with a maturity of 1 to 30 years. They are issued at face value, instead of capital appreciation the holder is entitled to a stream of coupon payments. The bond can be freely traded in the secondary bond market. The price of the bond once issued will fluctuate according to market conditions. There is an inverse relationship between the price of the bonds and the rate of interest. Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Bonds Example: If a bond is originally issued at $100 and each year it makes annual coupon payment of $10. It is issued at an annual rate of interest: If immediately upon issue the price of the bond were to rise in the secondary market to $120, then the coupon rate of interest would be: $ Keith Pilbeam ©: Finance and Financial Markets 4th Edition

The Operation of Monetary Policy Most countries have a central bank. Central bank is responsible for the operation of monetary policy, changing the money supply held by banks and the public and targeting the short-term interest rates prevailing in the money markets. There are three types of monetary policy. Neutral Contractionary Expansionary Keith Pilbeam ©: Finance and Financial Markets 4th Edition

The Effects of an Expansionary Monetary Policy Expansionary OMO: An open market operation that increases the narrow money supply and lowers the short-term interest rate. In this policy, central bank purchases short-term financial securities (usually Treasury bills). Public holds more money but less Treasury bills. Central bank has an increase in its liabilities (money circulation with the public) but also a corresponding increase in its assets ( Treasury bills). An expansionary OMO increases the demand for bills, raises the price of bills and hence lowers short-term interest rates. Keith Pilbeam ©: Finance and Financial Markets 4th Edition

The effects of an expansionary OMO Keith Pilbeam ©: Finance and Financial Markets 4th Edition

The Effects of a Contractionary Monetary Policy Contractionary OMO: An open market operation that decreases the narrow money supply and raises the short-term interest rate. Central banks sells newly issued Treasury bills that are issued on behalf of the Treasury. Public holds less money but more Treasury bills. Central bank has a decrease in its liabilities (money in circulation with the public), but also a corresponding decrease in its assets(Treasury bills). A contractionary OMO, by increasing the supply bills, lowers the price of bills and hence raises the short-term interest rate. Keith Pilbeam ©: Finance and Financial Markets 4th Edition

The effects of a contractionary OMO Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Summary of expansionary and contractionary monetary policies Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Monetary Policy in Practice and The Announcement Effect In the USA, the Federal Reserve Open Market Committee (FOMC) meets every four to six weeks to discuss its target for short term interest rate. In the UK , the Monetary Policy Committee (MPC) meets periodically to discuss its target short-term interest rate. These meetings are crucial to the implementation of monetary policy since at the end of the meeting an announcement is made concerning the short term interest rate. The Committee will announce its target short-term rate which may be higher or lower than the market was expecting. Keith Pilbeam ©: Finance and Financial Markets 4th Edition

The Effects of an Unexpected Cut in the Short-Term Interest Rate If an unexpected cut in interest rates is announced, then the market will do the work for the central bank without it having to buy Treasury Bills. With an announced interest rate rate cut then Treasury bill prices rise. Private agents want to hold less money but more bills in their portfolios to make a capital appreciation from the rise in Treasury bills price. Money demand shift to the left. Demand for Treasury bills shift to the right. The market automatically moves to the desired interest rate without an increase in the money supply. Keith Pilbeam ©: Finance and Financial Markets 4th Edition

The effects of an unexpected cut in the short-term interest rate Keith Pilbeam ©: Finance and Financial Markets 4th Edition

The effects of an unexpected rise in the short-term interest rate If there is an unexpected announcement of a rise in the short term interest rate. Treasury bills prices will fall. Private agents want to hold fewer Treasury bills and more money in their portfolios to avoid capital loss from the fall in Treasury bill prices. Money demand shift to the right. Supply of Treasury bill traded increases with a shift to the right. The market will automatically move to the desired interest rate without a fall in the money supply. Keith Pilbeam ©: Finance and Financial Markets 4th Edition

The effects of an unexpected rise in the short-term interest rate Keith Pilbeam ©: Finance and Financial Markets 4th Edition

The Commercial Banking System and Narrow & Broad Money Supply Narrow Money Supply(M0): Cash held by the non-bank public and cash reserves held by the banking system. M0=Notes + coins + reserves of the banking system Broad Money Supply (M1): The narrow money supply plus sight deposits held by the banking system. M1=Notes + coins+reserves of the banking system + sight deposits Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Table 4.1 The relationship between base money, bank deposits and broad money Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Broad Money Supply=Money Multiplier*Monetary Base The link between the monetary base and the broad money supply is given by the money multiplier: Broad Money Supply=Money Multiplier*Monetary Base The banks’ desired ratio of cash reserve [R] to total deposits [D] is given by r: r=R/D The public’s desired ratio of cash in circulation [C] to banks’ deposits [D] is given by c: c=C/D The total reserves of the banking system [R] is given by the reserve ratio times the volume of the deposits: R=rD Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Money Multiplier Total cash held by the public is given by the volume of deposits times the cash holding ratio of the public: C=cD The monetary base is defined as cash held by the banks plus cash held by the non bank public: B=C+R=(c+r)D The broad money supply(M1), is currency in circulation plus banks’ demand deposits: M1=C+D=(c+1)D Money Multiplier: M1=(c+1)B/(c+r) Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Money Multiplier Example: Monetary base is £100 million. c=0.2, r=0.1 The money multiplier is 4. The broad money supply is four times the narrow money supply. Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Controlling the Money Supply The value of the money supply is affected by changes in either the money multiplier or changes in the money base. Contractionary /Expansionary Open Market Operations Raising/Lowering the Reserve Requirement Raising /Lowering the Central Bank Lending Rate Keith Pilbeam ©: Finance and Financial Markets 4th Edition

The Determination of Interest Rates The rate of interest is determined in the money market by the supply and demand for money. Money demand has three types -Transactions demand, Speculative demand & Precautionary demand Transaction Demand is a positive function of income. Mt=Mt[Y] Mt: Transaction demand for money Y: Level of the national income Speculative Demand has an inverse relationship with the rate of interest. Msp=Msp[r] Msp: Speculative Demand for Money r: the rate of interest Keith Pilbeam ©: Finance and Financial Markets 4th Edition

The Determination of Interest Rate Money supply is determined exogenously by the authorities. In equilibrium, money demand(Md), made up of transactions and speculative balances, is equal to money supply(Ms): Md=Msp+Mt=Ms Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Figure 4.6 The supply and demand for money Keith Pilbeam ©: Finance and Financial Markets 4th Edition

The effect of increases in money demand and money supply on the short term interest rate Keith Pilbeam ©: Finance and Financial Markets 4th Edition

The Loanable Funds Approach to Interest Rate Determination This approach argues that economic agents have a certain amount of financial wealth and they can choose to hold this wealth in the form of either interest-earning financial assets or in money which earns no interest, or some combination of two. The Supply of Loanable Funds The stock of loanable funds is the stock of financial assets on which interest is paid. It is determined by three factors: The amount of savings Switches from money holdings into savings products An increase in loans made by financial institutions A rise in the interest rate lead to an increase in all of these factors giving an upward-sloping supply of loanable funds. Keith Pilbeam ©: Finance and Financial Markets 4th Edition

The Loanable Funds Approach to Interest Rate Determination The demand for loanable funds represents the demand for an increased stock of debt, to finance present aggregate demand in the form of consumption, investment and government expenditure on goods and services. It is determined by three factors: Investment Demand Borrowing for Consumption Increases in Money Demand A rise in the interest rate leads to a fall in all of these three factors, giving a downward-sloping demand of the loanable funds. The intersection of the supply and demand for loanable funds determines the interest rate. Keith Pilbeam ©: Finance and Financial Markets 4th Edition

The demand and supply of loanable funds Keith Pilbeam ©: Finance and Financial Markets 4th Edition

The effects of increases in demand and supply of loanable funds Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Inflation and Interest Rates Nominal interest rate is divided into three components. r: nominal rate of interest i: real rate of interest under conditions of inflation certainty :expected inflation rate Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Inflation and Interest Rates Example: In Country A, the nominal rate of interest is 8%. Assume that inflation rate may vary between the three values 3%, 5% and 7%. The average expected inflation rate is 5%, but lenders of funds might find that inflation is 7%, which would reduce the real return so they charge a 1% inflation risk premium. If lenders are absolutely sure that the inflation rate will be 5%, there will be no need to charge inflation risk premium, and the nominal interest rate would be 7%. Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Other factors that affect the interest rate Default Risk Highly rated companies with good credit ratings are able to borrow funds at a lower interest rate than companies with poor credit ratings. Loans to the government are considered as risk-free (when the debt is denominated in their own currency and they have the ability to print that currency). Liquidity Risk The less liquid the security, the higher the interest rate Duration of a Loan The longer the duration, the higher the interest rate (generally speaking but not always – see negatively sloped yield curve) Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Theories of the Yield Curve Yield curve plots the yield to maturity of Treasury Bills and Treasury Bonds with different terms to maturity issued by the government. Positively-Sloped Yield Curve: A government that wishes to borrow for a long period of time pays a higher yield than for medium-term borrowing, which in turn has a higher yield than for short-term borrowing. Negatively-Sloped Yield Curve: A government that wishes to borrow for a long period of time pays a lower yield than for medium-term borrowing, which in turn has a lower yield than for short-term borrowing Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Theories of the Yield Curve Hump-Shaped Yield Curve: A government that borrows medium-term is paying higher yields than for borrowing short-term or long-term. Flat Yield Curve: All short, medium, long term borrowings has pproximately with the same yield. Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Figure 4.10 Various yield curves Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Theories of the Yield Curve Expectations Theory Liquidity Preference Theory The Preferred Habitat Theory Market Segmentation Theory Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Expectations Theory Long-term interest rates are determined by market expectations about the path of future short-term interest rates. Positively-Sloped Yield Curve market participants expect that short-term interest rates will increase in the future. Negatively-Sloped Yield Curve market participant expect that short-term interest rates will fall in the future. Flat yield curve indicates that market participants expect that short-term interest rates remain fairly constant in the future. Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Expectations Theory Long-term interest rate: rn Long term interest rate on a bond with maturity of n years r0 Current one-year interest rate r1 One year interest rate expected in one year’s time r2 One year interest rate expected in two years’ time Example: Interest rate on a five year bond is the simple arithmetical average of all future known interest rates. Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Expectations Theory The following are the expected interest rates for the five-year bond: Current one-year interest rate: 7% One year interest rate expected in one year’s time: 8% One year interest rate expected in two year’s time: 9% One year interest rate expected in three year’s time: 10% One year interest rate expected in four year’s time: 11% Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Liquidity Preference Theory According to liquidity preference theory, the yield on long-term bonds reflects not only market expectations but also a liquidity premium. Liquidity Premium: The extra yield required to hold securities that are less liquid than securities with similar risk features. It predicts a generally higher interest rate than the pure expectations theory. The theory assumes that lenders of funds prefer to lend short, borrowers prefer to borrow long. Borrowers are prepared to pay a liquidity premium to lenders to induce them to lend long. The size of the liquidity premium increases with the time to maturity. Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Preferred Habitat Theory The theory argues that the term structure reflects both the expectations of the future path of interest rates and a liquidity premium. However, liquidity premium does not have to rise uniformly with the maturity of the bond as assumed by the liquidity preference theory. Example: If both short and long-term investments are preferred habitats, then medium-term interest rates may be higher to induce investors to undertake medium-term investments. Example: If most investors have a preferred habitat of five-year investments, the short-term and long-term interest rates may be both higher to induce investors to accept investments at these time horizons. Could lead to a U shaped yield curve Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Market Segmentation Theory This theory assumes that there are barriers to switching between short, medium and long-term investments. These barriers may be due to the need to meet regulatory requirements, may be self-imposed regulations or even transaction costs. The shape of the yield curve is determined by separate supply and demand forces in each particular maturity segment. Changes in interest rates in a particular segment of the market will have relatively little influence on other segments of the market. Keith Pilbeam ©: Finance and Financial Markets 4th Edition