Impact of the Changes in UK Interest Rates on UK Exchange Rate Against US$ over Last Five Years - Term Paper Example

Report on: Impact of the changes in UK Interest Rates on UK exchange rate against US$ over last five years. Terms of Reference The Chairman, XXX Company, Fax: 000-000-000 From: Mr. AAA, Financial Analyst, XXXX Consulting Plc. Abstract Changing interest rate affect the exchange rate and deprecates the domestic currency as flow of currency from abroad is reduced. Interest rate and exchange rate has positive correlation Import cost rise as bank rate drops. Investment in industrialization reduced. Demand for goods exceed supply and raise inflation rate. As interest rate changes investor changes the market movement. If money market cannot provide enough return for investor they will tend to move their fund to capital market. So, new point of equilibrium is established. This paper would go to analyse the Impact on UK exchange rate against US$ over last five years due to recent MPC's 1 cut on interest rate. Contents Page Terms of Reference 1 Abstract 1 Contents Page 2 Introduction 2 Methodology 3 Theoretical Aspect of Interest Rate 4 Analysis of UK Interest Rate Cut 6 Equilibrium Determinacy 8 UK pound 9 Market B: High risk securities 9 Market A: Low risk securities 9 Conclusion 11 Bibliography: 12 Appendix 14 Table-1 14 Table -2 14 Table -3 15 Table- 4 15 Introduction The pragmatic correlation among money, real output and interest rates has been attributed significantly with business cycle, monetary transmission mechanism, aggregate money demand and identification of monetary policy rules. There is no accords of interest rate to which should be included as an empirical models for exchange rate To providing the analyse the interdependency of Interest rate and Exchange rate, Fisher definition would not be relevant to economic analysis. So this paper would follow Keynes and other post-Keynesians notion of real rate and exchange rate. Smithin, J. (2003) mentioned that regulating interest rates for exchange rate cannot guard the purchasing power and it is quite unfeasible to do at the macroeconomic level. There is an empirical evidence of the break in the relationship between interest rates, exchange rate and inflation ever since 1953. Methodology The present analysis of UK interest rate cut and impact on US$ are relevant to specifying the monetary policy system pursued by the two monetary authorities. This paper assumes that the monetary authority regulates the short-term ostensible interest rate. According to classical Taylor theory the instrument is set to act in response to domestic inflation as well as output gap. On the other hand in open-economy model specificities more controversial reasoning the set of variables in the direction of which monetary policy can react is superior. The present strategy is to discover the consequences for the equilibrium allotment of simple rules, which lead to equilibrium that can be worked out analytically to understanding the transmission mechanism under open economies. The analyse go with three regimes and label as: - a) a fixed exchange rate; b) a floating exchange rate c) a managed exchange rate, Theoretical Aspect of Interest Rate First level let consider the rules that establish a fixed nominal exchange rate. Pigeon, M. A. (2004) added that it would demonstrate that in principle numerous fixed exchange rate regimes subsist on the specification of the fundamental rules. Thus a floating regime that is defined as a command in which the interest rates in both countries don't respond explicitly to the exchange rate. It would be characterised as where & is non-negative; here its combination of rules as floating command . These rules have been broadly used in the closed-economy literature. Most of the policymaker reacts to precedent movements in the interest rate, present household producer inflation rate and output gap. According to classical Taylor rules, the coefficients and are zeros.2 Benigno, G, & Benigno, P. (2006) argued within the floating-exchange regime, we consider also rules in which the reaction is toward the domestic price level- here are non-negative and & are the log of the relevant price level. Benigno, G, & Benigno, P. (2006) also added that the managed exchange rate, a 'dirty' floating. Considering the belongings in which a country reacts moreover to changes in the nominal exchange rate as well as the deviations of the level of the exchange rate from a defined objective. On the other hand a managed exchange rate is defined as a connect of rules of the form as - here non-negative where indicates the log-deviation of the exchange rate from a target , so a managed exchange rate is defined as - Here non-negative and is the exchange rate objective. Analysis of UK Interest Rate Cut The Bank of England's monetary policy committee voted to cut down the bank rate by a quarter point to 5.25%. This cut down has a vast impact on the exchange rate against the US$. England is facing troubles as growth rate in industrialisation is declining; percent drop in manufacturing in November 2007. Enders, W. (2003) and Hicks, J. R. (1939) pointed out that among various signs, housing sector is in a terrific condition as many of houses are unsold and number of new mortgage approvals has dropped. Consumer confidence level sharply declined. So, central bank takes the decision to cut the current bank rate. The relationship between bank rate and exchange rate has a perfect positive closer relationship. The correlation coefficient is .802. It indicates, as bank rate is going down, UK currency is deprecating against USA currency and vice versa. The R Square .643 means that 64% of the variation in the dependant variable has been explained by the independent variable. As bank rate is dropped, people can borrow more money from financial institutions. So, the consumption level will increase than existing level. To meet up the demand, production will increase as manufacturers can boost up money supply by injecting capital. On the other hand it may not be possible to meet the entire or specific demand. So, people and manufacturers will tempt to import goods, raw materials, services from abroad like USA. So a great portion of foreign reserve may be lessened. As, demand for US$ dollar is high and supply is limited a new equilibrium point will be established by deprecating the value of UK pound. As bank rate is dropped, depositors from USA will not incline to invest in UK banks, as fixed return is lower. They will tend to move their money elsewhere. So, the inflow of USA currency and reserve against UK will decline. In context with demand supply theory UK currency will be deprecated against USA currency. Arbitrager from USA will buy more UK currency to sell it to another country. So, huge amount of gain will be occurred and consequently the reserve for UK pound will fall against dollar and again UK currency will be depreciated. In accordance with interest-rate-parity theorem, if interest rates are lower domestically, the foreign currency will be selling at a discount in the forward market. The graph shows the relationship between official bank rate and exchange rate. Though bank rate is increasing it is cut down recently by 5.25% Equilibrium Determinacy The bank of England' monetary policy committee voted to cut down the bank rate by a quarter point to 5.25%. This cut down has a vast impact on the exchange rate against the US$. Money market holds short-term instruments with short-term interest and short-term liquidity. Capital market holds long-term instruments with long-term interest and long-term liquidity. Risk is low in money market and high in capital market. Changes in bank rate affect both the market. Bank rate is determined through demand and supply of funds. This is explained below: The level of short term and long-term interest rates and differences between the two In market A when interest rate falls, money inflow declines and vice versa. So, if investors assume that interest will fall in near future again, they may shift their funds to Market B where return is 12% with higher liquidity. As, more funds is shifting to Market B, central bank may raise the bank rate to stabilize money supply in Market A and again funds will shift. So, interest rate affects the short term and long term interest rates. If we assume investors are rational, a decrease in interest rates will prompt investors to move money away from the bond market to the equity market. Common money market instruments includes: Bankers' acceptance, Certificate of deposit, repurchase agreements, commercial paper, Eurodollar deposit, treasury bills, money market mutual funds. Capital market's instruments include treasury notes and bonds, mortgage, state and local government bonds, corporate bonds, leases, preferred and common stocks. The quarter point cut in interest rates should provide relief to borrowers on tracker mortgages. Figures from McCallum, B. T. & Nelson, E. (1999) & Maurice, O. (1997) suggest that someone on a 100,000 mortgage over 25 years will see their monthly repayment slashed by 14.84. Someone on the same mortgage but only paying the interest will save 20.83 a month. As well as saving money on their monthly repayments, McCallum, B. T. & Nelson, E. (1999) says people on tracker rate mortgages - which account for between 25% and 30% of the market - could take advantage of the rate cut by using the savings to make overpayments. Commercial papers are issued by commercial banks in UK to raise their fund. As interest rate drops these commercial bank will decline the rate of issuing commercial paper. So, bank may suffer from shortage fund. Pensions fund plans funded by corporation or government. As interest rate drops workers will tend to go for raise their remuneration. So, cost of production will increase and price of necessary goods will increase will lead to higher inflation. Table-1 represents the short-term interest rate with comparing UK official bank rate. The overall relation is positive as both are elements are increasing. The deprecating UK pound is increasing the short term interest rate indicates investors are moving away from capital market. So, later government may introduce the rate of interest rate in by analyzing capital market scenario. Also the last two column represent long-term rate is somewhat increasing as interest cut. Conclusion From above paragraph it is seen that bank rate cuts will flow the fund towards different sources. As, depositors or investor move their fund to capital market or money market. Mutual funds are corporations that accept money form savers and then use these funds to buy stocks, long-term bonds or short-term debt instruments. So, if interest rate drops savers will tend to move their fund to capital market for high liquidity and return. The official bank rate and UK Treasury bill return has smaller positive correlation. It is about .27. So, the changes in Treasury bill return are slightly matched with bank rate. Bibliography: Benigno, G, & Benigno, P. (2006), Exchange Rate Determination under Interest Rate Rules, Seminner Working Paper, Bank of England. Ball, L., (1999), Policy Rules for Open Economy, Taylor, J., ed., Monetary Policy Rules, University of Chicago Press, pp.125-140 Pierpaolo, B., (2004), Optimal Monetary Policy in a Currency Area, Journal of International Economics 63(2): pp.229-325. McCallum, B. T. & Nelson, E. (1999), Nominal Income Targeting in an Open-Economy Optimizing Model, Journal of Monetary Economics, 43: pp.555-580. Maurice, O. (1997), Open Economy Macroeconomics: Developments in Theory and Policy, Working Paper No. 6319, NBER. Woodford, M., (2003), Interest and prices: foundations of a theory of monetary policy, Working Paper, Princeton University Press: Princeton. Yun, T., (1996), Nominal price rigidity, money supply endogeneity, and business cycles, Journal of Monetary Economics (37) 2 pp. 350-365. Tymoigne, E. (2006), Fisher's Theory of Interest Rates and the Notion of "Real": A Critique, Department of Economics, California State University, Working Paper No. 483. pp.23-68. Clarida, R., J. et al (2000), Monetary policy rules and macroeconomic stability: Evidence and some theory, Quarterly Journal of Economics 115(1): 145-169. Cottrell, A. (1994), Keynes and the Keynesians on the Fisher effect, Scottish Journal of Political Economy, 47(4): 420-450. Enders, W. (2003), Applied Econometrics of Time Series, 2nd ed. Hoboken, New York, Wiley. Hicks, J. R. (1939), Value and Capital.2nd ed. Oxford: Oxford University Press. Pigeon, M. A. (2004), Interest rate policy and the Bank of Canada: Setting the agenda, Lavoie, M. and Seccareccia, M. eds., Northampton, London.: Edward Elgar. Smithin, J. (2003), Controversies in Monetary Economics. Northampton, London: Edward Elgar. Wray. Data Sources: < http://uk.finance.yahoo.com/ > < http://money.howstuffworks.com > < http://www.measuringworth.com/interestrates > < http://www.marketoracle.co.uk/Article27.html > < http://www.ft.com > Appendix Table-1 Year UK Short-Term Rate: Ordinary Funds, Contemporary Series UK Short-Term Rate: Ordinary Funds, Consistent Series UK Short-Term Rate: Surplus Funds, Contemporary Series UK Short-Term Rate: Surplus Funds, Consistent Series UK Long-Term Rate: Contemporary Series UK Long-Term Rate: Consistent Series 2004 4.44 4.44 4.58 4.58 4.69 4.69 2005 4.55 4.55 4.69 4.69 4.33 4.33 2006 4.65 4.65 4.80 4.80 4.17 4.17 2007 5.53 5.53 5.96 5.96 4.56 4.56 Source: Copyright 2007 Lawrence H. Officer Table -2 Nature of relationship between interest rate and exchange rate Model R R Square Adjusted R Square Std. Error of the Estimate Change Statistics R Square Change F Change df1 df2 Sig. F Change 1 .802(a) .643 .524 .06168 .643 5.403 1 3 .103 Table -3 Period Official Bank Rate Exchange Rate (British pound to US dollar) 2004, Jan 3.75 1.82 2005,Jan 4.75 1.89 2006,Jan 4.5 1.77 2007,Jan 5.25 1.965 2008,April 5.25 1.975 Table- 4 Period Official Bank Rate UK treasury Bill Returns 2004, April 3.75 1.4108 2005,Jan 4.75 3.2075 2006,Jan 4.5 4.745 2007,Jan 5.25 4.28 2008,April 5.25 1.526 Read More