Links between Interest, and Exchange Rates
Do
they move in the same direction or in opposite directions? In the USA
in the late 1970s they moved in different directions- when short term
rates doubled the trade weighted ER appeared to be considerably
different.
We can examine the relationship when both rates are determined by market forces. We can use the trade weighted ER or the Real Effective ER where the ER is fixed or maintained by the central bank. When they are out of alignment of their natural relationship under free market forces, then there will be adverse consequences to the economy in the form of macro-economic imbalances- the domestic economy or the Balance of Payments.
We must first understand the markets in which these rates are determined with or without the direction of the central bank. Consider the markets for the structure of interest rates. The short term and long term interest rates are governed by different factors. In the short term market the central bank plays a role for the banks park their money for overnight use or for very short periods of a day or two. The central bank decides the rate on the basis of its short term monetary policy objective of either tight money or loose money. The CB rates are called the Standing Deposit Facility Rate effective 02 January 2014, is 6.5%.It provides the floor rate for the absorption of overnight excess liquidity from the banking system by the central bank.
Standing Lending Facility Rate:
This is the Interest rate applicable on reverse repurchases transactions of the Central Bank with commercial banks on an overnight basis under the Standing Facility, providing the ceiling rate for the injection of overnight liquidity to the banking system by the central bank.
Banks borrow and lend money in the interbank market in order to manage liquidity and meet the requirements placed on them. The interest rate charged depends on the availability of money in the market, on prevailing rates and on the specific terms of the contract, such as term length. Banks are required to hold an adequate amount of liquid assets, such as cash, to manage any potential withdrawals from clients. If a bank can't meet these liquidity requirements, it will need to borrow money in the interbank market to cover the shortfall. Some banks, on the other hand, have excess liquid assets above and beyond the liquidity requirements. These banks will lend money in the interbank market, receiving interest on the assets. There is a relationship between the Central Banks Standing Facility rates and the Inter-bank rates.
Next there is the Treasury Bill market at weekly auctions by the CB.3, 6 and 12 months TBs are offered for tender. Much of the new money goes to repay maturing TBs. But there is a net increase to meet the cash needs of the Treasury,
Next there is the Treasury Non market- both a primary market where the CB calls for offers for T Bonds varying from 1 year to even 30 years.
How are the different interest rates related? Long term bonds require higher rates of interest in the primary market since there is the risk of inflation in the long term. There is a secondary market in bonds as well which a market among Primary Dealers and their customers is. The rates of interest in the primary market- the new issue market is affected by the rates of interest or yields in the secondary market. The yield depends on the resale value of the bond in the secondary market. Bond prices in the secondary market fluctuate. When the bond prices fall the yield or the interest rate rises for the new buyer gets the coupon rate of interest on a lower price paid for the bond to purchase in the secondary market. Then higher rates will be demanded in the primary market for new bonds issued by the govt- CB. There is arbitrage between the primary market and secondary markets for bonds enabling a profit opportunity for the primary dealers and large holders of bonds like the Insurance Companies.
The CB would like to control the interest rates in all the markets but it cannot control the long term bond market. Even in the short term market it can do so not by fiat but varying the liquidity in the market by either open market operations- buying or selling government securities or by buying and selling foreign exchange to maintain the exchange rate from rising or falling outside the band in which it wants to maintain it.
The Foreign Exchange Market
It is a spot market as well as a forward market where banks participate buying and selling for their customers as well as for themselves to trade at a profit. Some banks may have a surplus of dollars while others may be short and then they want to buy. The banks with a surplus will hold the surplus in foreign exchange or sell it for Rupees depending on the return they get from the trade. The CB doesn't allow the banks to hold more than the working balances to prevent them from speculating by hoarding dollars when the market is short. What would happen to the ER depends on the CB. It holds the nominal ER within a narrow band and to do so it must sell when the market is short and the rate tends to rise or buy the surplus in the market when the Rate tends to fall below the band minimum.
There is also the forward market when merchants who need dollars in a month or a few months would like to ensure that the ER will not go against them for they would have priced their goods at the prevailing ER. So they like to buy forward or the exporters like to sell forward if they think the ER will go against them. If there is no expectation in the market of either an appreciation or depreciation the spot and forward rates will differ only by the interest element for the future period- 1 month or 6 months.
Real Rate of Interest is delivered by the market supply and demand of funds from individuals, firms and the government. In an open economy there is also the flow of funds from foreigners outside. The real rate of interest tends to rise or fall as the demand for funds grows faster than the supply. The demand for funds increases when the government runs a larger budget deficit and wants to borrow more. It crowds out the private investment borrowings driving up the real; rate of interest.
Nominal and Real Exchange Rates
Unlike the nominal Nominal ER the Real Rate is not a rate of currency exchanged. Rather it is the Relative Price of foreign goods to domestic goods prices. So it reflects the under-lying Terms of Trade between domestic goods (exports) and foreign goods (imports). The relationship between the Nominal ER and the Real Rate is given by the formula
E= q (P*/P) where E is the nominal ER and q is the Real ER, P* is the foreign Price level and P is the domestic Price Level.
Q= e/ (P*/P).
Changes in the domestic and foreign price levels influence the nominal ER. When domestic price level rises faster than the foreign price level, the nominal Nominal ER depreciates because foreigners reduce their purchases of domestic goods and this reduces the availability of dollars in the foreign exchange market.
The CBSL calculates what it calls the Nominal and Real Effective Exchange Rates to determine the trend of the Real Exchange Rate. In 2013 the Real ER appreciated.
Inflation is the main channel linking the Interest Rate and the ER. Since nominal interest rates depend on expected inflation while Nominal ER depend on the relative values of the foreign and domestic price levels, an inflation shock will affect both nominal interest rates and nominal ER Inflation shocks are expected to lead to a negative correlation between nominal interest rates and the Nominal ER.
Suppose the price of oil rises leading to higher domestic inflation. To the extent there is pass- through and higher inflation or higher inflation expectations are built into the system nominal interest rates will tend to rise. If domestic inflation exceeds foreign inflation the nominal ER will tend to fall. (Real ER will rise).
Similarly deflation could lead to a negative relationship between interest rates and Exchange Rates
We can examine the relationship when both rates are determined by market forces. We can use the trade weighted ER or the Real Effective ER where the ER is fixed or maintained by the central bank. When they are out of alignment of their natural relationship under free market forces, then there will be adverse consequences to the economy in the form of macro-economic imbalances- the domestic economy or the Balance of Payments.
Do they move in the same direction or in
opposite directions? In the USA in the late 1970s they moved in
different directions- when short term rates doubled the trade weighted
ER appeared to be considerably different.
We can examine the relationship when both rates are determined by market forces. We can use the trade weighted ER or the Real Effective ER where the ER is fixed or maintained by the central bank. When they are out of alignment of their natural relationship under free market forces, then there will be adverse consequences to the economy in the form of macro-economic imbalances- the domestic economy or the Balance of Payments.
We can examine the relationship when both rates are determined by market forces. We can use the trade weighted ER or the Real Effective ER where the ER is fixed or maintained by the central bank. When they are out of alignment of their natural relationship under free market forces, then there will be adverse consequences to the economy in the form of macro-economic imbalances- the domestic economy or the Balance of Payments.
We must first understand the markets in which these rates are determined with or without the direction of the central bank. Consider the markets for the structure of interest rates. The short term and long term interest rates are governed by different factors. In the short term market the central bank plays a role for the banks park their money for overnight use or for very short periods of a day or two. The central bank decides the rate on the basis of its short term monetary policy objective of either tight money or loose money. The CB rates are called the Standing Deposit Facility Rate effective 02 January 2014, is 6.5%.It provides the floor rate for the absorption of overnight excess liquidity from the banking system by the central bank.
Standing Lending Facility Rate:
This is the Interest rate applicable on reverse repurchases transactions of the Central Bank with commercial banks on an overnight basis under the Standing Facility, providing the ceiling rate for the injection of overnight liquidity to the banking system by the central bank.
Banks borrow and lend money in the interbank market in order to manage liquidity and meet the requirements placed on them. The interest rate charged depends on the availability of money in the market, on prevailing rates and on the specific terms of the contract, such as term length. Banks are required to hold an adequate amount of liquid assets, such as cash, to manage any potential withdrawals from clients. If a bank can't meet these liquidity requirements, it will need to borrow money in the interbank market to cover the shortfall. Some banks, on the other hand, have excess liquid assets above and beyond the liquidity requirements. These banks will lend money in the interbank market, receiving interest on the assets. There is a relationship between the Central Banks Standing Facility rates and the Inter-bank rates.
Next there is the Treasury Bill market at weekly auctions by the CB.3, 6 and 12 months TBs are offered for tender. Much of the new money goes to repay maturing TBs. But there is a net increase to meet the cash needs of the Treasury,
Next there is the Treasury Non market- both a primary market where the CB calls for offers for T Bonds varying from 1 year to even 30 years.
How are the different interest rates related? Long term bonds require higher rates of interest in the primary market since there is the risk of inflation in the long term. There is a secondary market in bonds as well which a market among Primary Dealers and their customers is. The rates of interest in the primary market- the new issue market is affected by the rates of interest or yields in the secondary market. The yield depends on the resale value of the bond in the secondary market. Bond prices in the secondary market fluctuate. When the bond prices fall the yield or the interest rate rises for the new buyer gets the coupon rate of interest on a lower price paid for the bond to purchase in the secondary market. Then higher rates will be demanded in the primary market for new bonds issued by the govt- CB. There is arbitrage between the primary market and secondary markets for bonds enabling a profit opportunity for the primary dealers and large holders of bonds like the Insurance Companies.
The CB would like to control the interest rates in all the markets but it cannot control the long term bond market. Even in the short term market it can do so not by fiat but varying the liquidity in the market by either open market operations- buying or selling government securities or by buying and selling foreign exchange to maintain the exchange rate from rising or falling outside the band in which it wants to maintain it.
The Foreign Exchange Market
It is a spot market as well as a forward market where banks participate buying and selling for their customers as well as for themselves to trade at a profit. Some banks may have a surplus of dollars while others may be short and then they want to buy. The banks with a surplus will hold the surplus in foreign exchange or sell it for Rupees depending on the return they get from the trade. The CB doesn't allow the banks to hold more than the working balances to prevent them from speculating by hoarding dollars when the market is short. What would happen to the ER depends on the CB. It holds the nominal ER within a narrow band and to do so it must sell when the market is short and the rate tends to rise or buy the surplus in the market when the Rate tends to fall below the band minimum.
There is also the forward market when merchants who need dollars in a month or a few months would like to ensure that the ER will not go against them for they would have priced their goods at the prevailing ER. So they like to buy forward or the exporters like to sell forward if they think the ER will go against them. If there is no expectation in the market of either an appreciation or depreciation the spot and forward rates will differ only by the interest element for the future period- 1 month or 6 months.
Real Rate of Interest is delivered by the market supply and demand of funds from individuals, firms and the government. In an open economy there is also the flow of funds from foreigners outside. The real rate of interest tends to rise or fall as the demand for funds grows faster than the supply. The demand for funds increases when the government runs a larger budget deficit and wants to borrow more. It crowds out the private investment borrowings driving up the real; rate of interest.
Nominal and Real Exchange Rates
Unlike the nominal Nominal ER the Real Rate is not a rate of currency exchanged. Rather it is the Relative Price of foreign goods to domestic goods prices. So it reflects the under-lying Terms of Trade between domestic goods (exports) and foreign goods (imports). The relationship between the Nominal ER and the Real Rate is given by the formula
E= q (P*/P) where E is the nominal ER and q is the Real ER, P* is the foreign Price level and P is the domestic Price Level.
Q= e/ (P*/P).
Changes in the domestic and foreign price levels influence the nominal ER. When domestic price level rises faster than the foreign price level, the nominal Nominal ER depreciates because foreigners reduce their purchases of domestic goods and this reduces the availability of dollars in the foreign exchange market.
The CBSL calculates what it calls the Nominal and Real Effective Exchange Rates to determine the trend of the Real Exchange Rate. In 2013 the Real ER appreciated.
Inflation is the main channel linking the Interest Rate and the ER. Since nominal interest rates depend on expected inflation while Nominal ER depend on the relative values of the foreign and domestic price levels, an inflation shock will affect both nominal interest rates and nominal ER Inflation shocks are expected to lead to a negative correlation between nominal interest rates and the Nominal ER.
Suppose the price of oil rises leading to higher domestic inflation. To the extent there is pass- through and higher inflation or higher inflation expectations are built into the system nominal interest rates will tend to rise. If domestic inflation exceeds foreign inflation the nominal ER will tend to fall. (Real ER will rise).
Similarly deflation could lead to a negative relationship between interest rates and Exchange Rates
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