Real vs Nominal Interest - Coursework Example

Introduction The rate of interest is one of the most important channels through which effects of monetary policy are transmitted into the economy. Changes in the rate of interest alter the marginal cost of borrowing and lending which affects an economic agent’s cash flow and inter temporal consumption preferences thereby leading to changes in savings, investment and aggregate demand. So, the fact that changes in the rate of interest brought about by the central bank of any nation will have significant consequences on the real and monetary variables of the economy is hardly unexpected or in any way surprisingly stunning a conclusion. Generally the central bank changes the interest rate as a part of its inflation targeting monetary policy package. As a direct result of this rise in interest rate, commercial banks find borrowing from the central bank to be more costly now and thus overall lending out falls and the pace of the price movements slow down as there is a decline in overall spending. The objective of this paper is to first identify and briefly explore the possible channels through which such interest rate changes influences the real and nominal economic variables and then to look at the possible impact such a change can have on the market for housing. Real Vs Nominal Interest The first step, in identifying these channels and more importantly perceiving the mechanism through which they work, is distinguishing between real and nominal interest rates and clarifying how changes in nominal interest rates affect the real interest rate. The nominal interest rate refers to solely the monetary value of the price of borrowing funds while real interest rate refers to the effective cost of borrowing which incorporates the rate of inflation along with the nominal interest rate. So, we have the relation: Nominal interest rate – Inflation rate = Real interest rate. (The Fisher equation)1 Generally, the rate of interest refers to the nominal rate unless specifically mentioned. Thus, when we discuss the effects of changes in the interest rate by the central bank we are talking about the impacts of a change in the nominal rate of interest. The Substitution, Income and Wealth effects: exploring the mechanisms of transmission of interest rate changes The impact of a change in the interest rates can be very lucidly explained in terms of the substitution, income and wealth effects generated through interest rate movements. An increase (decrease) in the rate of interest (nominal or real) reduces (raises) the relative attractiveness of spending now as opposed to in future for economic agents. So, the nominal variables domestic credit, the quantity of domestic money as well as real demand all fall (rise). This is referred to as the substitution effect. Again the rise in the rate of interest re-distributes income from the borrowers to the lenders. But as the spending propensity of the lenders is generally relatively lower (a fact implied by the fact that they are lenders) this implies reduced spending overall. Furthermore, if the rise in lending rates is higher than that on the returns from assets then total incomes and therefore aggregate spending falls. This is the income effect. As higher interest rates are associated with reduced aggregate spending prices of assets like real estate and shares fall and this decline in wealth has a discouraging effect on spending. This is known as the wealth effect (Komárek & Melecký, 2001). Changes in the nominal rate of interest by the central bank, through these effects, can affect both, monetary or nominal variables like money demand, quantity of money, price level (or inflation rate) as well as real variables like investment in real terms, the demand for real output, real GDP etc, because the nominal interest rate changes translate to changes in the real rate of interest, provided the inflation rate, actual or expected, does not move corresponding to this change in nominal interest rate or to the changes in other macroeconomic variables (e.g. those influenced by fiscal measures, various domestic or foreign shocks etc.) in an offsetting manner so that the real rate of interest remains unaltered. The Major Channels of transmission Although we can identify numerous channels through which movements in central bank interest rates transmit into the economy at least through various indirect linkages, here we will restrict our discussion to the ones we feel to be the least indirect and most significant. The first of these is the aggregate demand channel. Suppose the central bank increases the rate of interest. The immediate impact of this is that investors find the process to be costlier as the price of borrowing has increased. So, there is a reduction in the inducement to invest. This causes a fall in the aggregate demand as a result of which real output falls. This reduction in real income then generates a reduction in consumption expenditure which again leads to a secondary reduction in real output via reduction in aggregate demand and this cycle goes on with a gradually dampening effect. So, the rate of inflation will also reduce (Mankiw, 2000). So, this is a combination of the substitution as well as income effects. The second channel that we identify is the expectations channel. In the presence of uncertainties, expectations play a crucial role in determining the effectiveness of any monetary policy. Consider the previous case and now allow for uncertainties. As soon as the central bank increases the rate of interest, people with rational expectations2 will expect a reduction in the rate of inflation (Sargent, 1982). As a result of this lowered inflation expectation, we shall have lowered wage rises and lowered actual inflation rate (Svensson, 1997). The third channel that we identify is the exchange rate channel. If a raised rate of interest will leads to an inflow of foreign capital thereby under a clean float exchange rate system will eventually leading to an appreciation of the exchange rate, imports become cheaper and thus the inflation rate falls. This is called the direct exchange rate channel. Again this appreciation leads to a reduced foreign import demand and some domestic demand also shifts in favour of domestic imports. Consequently, the demand for domestic produce falls. The inflation rate thus falls further. This is known as the indirect exchange rate channel (Svensson, 1997). Finally, we have the asset price channel which reflects the impact of a hike in the rate of interest by the central bank on the prices of bonds, shares, real estate, and other domestic assets. This is basically the channel through which the previously mentioned wealth effect operates. The channel operates through changes in firms’ market value which alters the relative price of new equipment, affecting investment spending and changes in household wealth thereby affecting household consumption and the availability of collateral for borrowing (Horváth & Maino, 2006). One must however take note of the fact that the efficacy of these channels depend upon a lot of factors, often structural to the economy in question. An important factor is the extent to which a change in the central bank controlled policy interest rate influences the term structure of the short term and long term money and other asset market rates. The transmission mechanism is significantly dependent upon institutional aspects like the structure and organisation of financial markets. Deeper and better organised markets have a lubricating effect in that transmissions are smoother and rapid and the agents’ actions thereby become more predictable and thus more controllable through central bank interest rate controls (Horváth & Maino, 2006). The market for housing and the effects of a change in the interest rate by the central bank The main channel through which interest rate changes transmit into the housing market is through the effects they have upon ease of availability of finances to both produce as well as purchase housing. However the aforementioned asset price channel via the wealth effect also has a crucial albeit secondary role to play. To understand the mechanism let us briefly go through the workings of the housing market. (Source: Malpezzi, 1999) The schematic diagram (from Mayo et al.,1986; Malpezzi, 1990) above shows how housing market inputs such as land, labour, finance, materials and infrastructure are combined by the supply-side agents to produce housing market services. Note that homeowners are included as producers due to their maintaining and upgrading activities. Relative prices serve as signals to producers regarding whether to supply more or less housing services while input suppliers decide upon providing more or less inputs. The crucial aspect to note here is that due to bulk of the investments required on both the demand and supply sides, housing markets are heavily dependent upon loaned finances. So, once the central bank decides to raise its rate of interest so that borrowing becomes more costly, it leads to a supply side contraction with investors becoming more choosy. With present stocks piling up there is a fall in the price of housing. On the demand side, with home loans becoming more costly, the potential buyers reduce in numbers for the moment or go for second best choices that meet their contracted inter-temporal budget constraints3. So although consumers face lowered prices due to the dependence upon credit resulting from the bulk of the required sum they fail to take advantage of this. The house owners observe a reduction in the prices of their already owned assets which makes them worse off via the asset price channel. This is the wealth effect. This may lead to them offering lowered prices (for either ownership rights or tenancy rights). The expectations channel also plays an important role. Once the central bank raises the rate of interest, people star expecting lowered prices for housing and that leads to them holding off their buying decisions to wait for price-cuts. This in turn leads to a reduction in demand and as a result the prices are actually lowered. These effects combined outweigh the income effect and so we find that all the previously mentioned channels play crucial roles so that interest rate hikes result in a contraction in the market for housing. An interest rate cut policy, given the nature of these channel would have exactly the opposite effects References: Humphrey, T.M. (1975), Interest Rates, Expectations and the Wicksellian Policy Rule, Federal Reserve Bank of Richmond Working Paper 75-2 Horváth, B. & Maino,R., (2006) “Monetary Transmission Mechanisms in Belarus”, IMF Working Paper, WP/06/246 Komárek, L & Melecký, M., (2001) Demand for Money in the Transition Economy:The Case of the Czech Republic 1993–2001, Warwick Economic Research Paper No. 614, The University of Warwick Malpezzi S., (1999) “Economic analysis of housing markets in developing and transition economies”, in Mills E.S. and Cheshire P. (Ed), Handbook of Regional and Urban Economics, Elsevier Science Pub Malpezzi, S. (1990), "Urban housing and financial markets: some international comparisons", Urban Studies, 27:971-1022. Mankiw, N.G., (2000) “macroeconomics” 4th ed, Worth publishers, New York Mayo, S.K., S. Malpezzi and D.J. Gross (1986), "Shelter strategies for the urban poor in developing countries". World Bank Research Observer 1:183-203. Sarjent, T.J., “The Ends of Four Big Inflations, “ in Hall, R.E, ed ., inflation: Causes and effects (Chicago: University of Chicago press, 1982) Svensson, L.E.O., (1997) “Inflation targeting in an open economy: Strict or flexible inflation targeting? “ , Reserve Bank of New Zealand working paper No. G97/8 Read More