Free «Monetary Policy» Essay Sample

The term structure of rate interest is a central concept in economics. It gives a clear indication of the price of allocation of goods, thereby, influencing investments, savings and, ultimately, economic growth. Interest rates are especially important in the case where long-term inflationary expectations are expected to come into play. Similarly, the subject of monetary policy transmission mechanism (MPTM) continues to generate interest internationally and within nations. The MPTM refers to a chain of actions through which a change in monetary policy stance is transmitted to attain objectives such as low inflation rates and economic growth.

The main way through which monetary policy actions are transmitted to the economy is through the effects on market interest rates. This is known as the interest channel of the MPTM. With regards to the interest rate channel, the MTPM is effective if monetary policy action is able to influence a range of interest rates, from short-term to long-term interest rates. However, while the effects of monetary policy on short term interest rates is considerably predictable, evidence of the influence of monetary policy on long-term interest rates is much weaker and less reliable.

  •  

    0

    Preparing Orders

  •  

    0

    Active Writers

  •  

    0%

    Positive Feedback

  •  

    0

    Support Agents

 

?
Type of service ?
Type of assignment ?
Number of pages ?
-
+
Academic level ?
Timeframes ?
Spacing ?
Currency ?
  • Total price
Continue to order
 

The rate of interests is mentioned frequently in the context of monetary policy, especially as an indicator of the stance policy or of market expectations. Although it is not viewed as a primary policy target, it is generally viewed to contain information that may be important to both policy authorities and market participants. Extensive literature has examined the informational and predictive content of interest rates with regard to the final aspects of monetary policy, namely real activity and inflation. In order to understand these relationships, it is important to look at the relationship between the immediate instruments of monetary policy and the spread between short-term and long-term government interest rates.

Monetary Policy and Interest Rates: Theory vs. Reality

From existing literature, a very short-term interest rate (a central bank rate) is labelled as the primary policy instrument. Normally, there is a credit market that is often used by the central bank to intervene in the domestic arena and over which the bank influences considerably. The use of short-term rate as the primary instrument of policy is not a universal monetary principle, either within one country or across nations. Nevertheless, the characterization has become common in the current times.

The central bank can control the yield curve spread to a significant degree through this short-term instrument. On the long-term, however, the effect will be determined by many factors, including real activity and long-term inflation rates. Moreover, Taylor argues that taking into consideration only theoretical materials it is difficult to determine which interest rate has greater effects on economic activity (consumption and investment demands). However, according to the author, there is a major reason to believe that for long-term decisions, like investing in machinery, the long-term interest rate is an aspect of greater interest. In the case where the long-term interest rate is considered for market demands, the effectiveness of the MPTM with regards to interest rate channel should depend on how monetary policy affects long term interest rate.

The studies show that monetary policy actions have predictable effects on short-term interest rates. For example, the study by Roley and Sellon (1995) show high responses of short-term rates of federal funds to monetary policy actions in the U.S. A study by Dale (1993) on the short-term response of the U.K. market rates to monetary policy actions by the Bank of England show that policy actions have significant positive effect on interest rates of any maturity. However, these effects decline with time.

While many economists agree that monetary policy actions have positive effects on short-term effects, the relationship between monetary policy actions and long-term interest rates is still unclear. With regards to theories on the term structure of interest rates, changes in short-term interest rates resulting from monetary policy action affect long-term interest rates differently. According to the theory of term structure, long-term interest rates are affected by monetary policy action by influencing short-term interest rates, as well as changing market expectations of future short-term rates (Walsh, 2003). Following this argument, the relationship between long-term interest rates and monetary policy actions is not a simple one.

The reactions between long-term and monetary policy actions can be highly variable, depending on the changes of market participants’ views and on how they perceive the future direction of monetary policy. According to Roley and Sellon (1995), market participants develop their future expectations of monetary policy depending on the impacts on short-term interest rates (forward rates), and, thus, long-term rates. However, the Market Segmentation Theory (MST) of the term structure of interest rate suggests that the relationship between interest rates and monetary policy should not be necessarily influenced by different maturities. The rationale behind this theory is that investors and borrowers have strong maturity preferences when they try to attain fixed income securities or when investing. As a result of these preferences, markets are divided into many small segments, each one having its unique demand and supply forces that determine the equilibrium results (interest rates) for each segment. Therefore, according to MST, the supply and demand conditions unique to the maturity segment are the major factors determining the interest rates for a maturity segment.

 
Get 24/7 Free consulting
Toll free

On the other hand, the preferred habitat theory is a variant of the MST and it combines the elements of the expectations and the segmented-markets hypotheses. According to this theory, investors have a preference for debt securities of a given term, but are willing to change their preferred terms if they expect compensation for such through earning a risk or term premium (Baye and Jansen, 1995).

Evidence from Studies on the Relationship between Policy Actions and Long-Term Interest Rates

Empirical results obtained from different studies confirm that there is a complex relationship between long term interest rates and monetary policy. A study, conducted by Cook and Hahn (1989), examined the effects of changes in the Federal Funds rate on market rates in the United States in the 1970s at various maturities during the changes in the Federal Funds rate. The findings indicate that changes in the Federal Funds rate caused great movements in short-term rate and smaller, but significant, dynamics in intermediate and long-term rates.

Another significant study regarding the market rate’s reaction to Federal Funds rate changes was done by Thornton (1998). This was done around the time of changes in the Federal Fund rates during the period between October 1989 and December 1997. Thornton discovered that the response of the 10-year and 30-year Treasury rates to the Federal Funds rates changes was not statistically significant. The author attributes this to the revision of the market outlook for inflation by market participants. As suggested by Romer and Romer (2000), the positive response of the long term interest rates to monetary policy should be considered a puzzle, because it is not consistent with standard monetary theory. According to the authors, inflation expectations should be reduced by an increase in Federal Funds, and, thus, the level of long-term interest rates would be reduced. Romer and Romer argue that the situation can be resolved by giving central banks access to private information about economic fundamentals and reducing to a minimum information asymmetry between central banks and market participants.

Save up to
25%!

We offer 10% more words per page than other websites, so actually you got 1 FREE page with every 10 ordered pages.

Together with 15% first order discount you get 25% OFF!

A study by Hardy (1998) shows that in Germany the reaction of market interest rates to changes in official interest rates depends on the extent to which the change is anticipated, and its interpretation as a signal for future policy. According to Hardy, German market interest rates responded significantly to changes in the official interest rates during the 1990s, and these responses are more evident when changes in the official rates are broken into anticipated and unanticipated changes.

Kaketsis and Surantis (2006) study the transmission process between the operating interest rates instruments of the Bank of Greece and the market interest rates at different maturities during the changes period in the 1990s. The results of their investigation indicate that during the transition period, policy changes produced an increase in anticipation and learning responses of market rates and a pronounced decline along the maturities spectrum. According to Ellingsen and Sodestrom, the presentation of changes in monetary policy determines the response of the long-term interest rates to monetary policy actions. According to the authors, changes in monetary policy can come from two distinct: the reaction of policy authorities to new and probably private knowledge about the economy (such as supply and demand shocks), or to changes in their policy preferences (monetary policy shocks). In the first scenario, policy is quiet endogenous, showing new input into a given objective function. In the second case, policy is exogenous, because while the input remains the same, the objective function is new. After an endogenous policy action, interest rates of all maturities are predicted to move in the same direction (Ellingsen and Sodestrom, 2001). However, short-term interest rates and long-term interest rates move in the opposite directions after introducing exogenous policy action. Peersman (2002), focusing on Ellingsen and Sodestrom’s study, suggest that if a bank becomes more averse of inflation, the burden of inflation in the objective function increases, which is caused by a positive policy shock that causes an unexpected increase in the short-term interest rate. Nonetheless, economic agents are made to adjust their inflation expectations downwards because of the changes in the monetary policy. Thus, positive exogenous monetary policy shock decreases long-term interest rates.

VIP services

Get
extended REVISION
2.00 USD

Get SMS NOTIFICATIONS 3.00 USD

Get an order
Proofread by editor 3.99 USD

Get an order prepared
by Top 30 writers 4.8 USD

Get a full
PDF plagiarism report
5.99 USD

Get
VIP Support 9.99 USD

VIP SERVICES
PACKAGE
WITH 20% DISCOUNT 23.82 USD

The Role of Expectations in the Monetary Transmission Mechanism

The studies above use the impulse response functions (IRF) gotten from the structural vector autoregressive (SVAR) model with long-term restrictions mainly characterize the responses of the short-term and long-term interests to demand, supply and monetary policy shocks. Research findings from these studies present that short-term and long-term interest rates show the same response after demand and monetary policy shocks. However, findings indicate that long-term interest rates and short-term rates together with supply shocks move in the opposite direction, contrary to the theory of Ellingsen and Sodestrom (2001). Economists suggest that one explanation why long-term rates decrease and short-term rates increase after supply shocks is the assumption that market participants believe that policy tightening as a reaction to supply shocks will be temporary and will lead to a significant easing of monetary policy in the future. This results to a fall in the expected future short-term rates (forward rates). As a result, the long-term rates fall while the short-term rates increase. This corresponds to the expectations of theory of the term structure of interest rate (Peersman, 2001). In addition, this explains why short-term and long-term interest rates increase in reaction to demand shocks. In fact, when short-term interest rates increase in reaction to demand shocks, market participants usually expect further increase in the short-term interest rates due to high inflation expectations (Moolman, 2002). As the result the expected future short-term rates (forward rates) will rise and, hence, there will be the observed increase in the long-term interest rate. Similarly, positive reactions of short-term and long-term interest rates to monetary policy shocks are due to market participants expecting forward rates to increase.

Drawing from the above findings, the short-term and long-term interest rates exhibit a positive reaction to monetary policy shocks indicating that monetary policy is capable of moving short-term and long-term interest rates in the same direction.

Top 30 writers

Get the highly skilled writer in the chosen discipline for $4.8 only!

Measuring the impact of policy on long-term rates

The expectations theory continues to describe implications for measuring the effect of policy actions on market interest rates. As discussed above, a major part of the response of long-term rates to monetary policy actions arise from the effects of anticipated future policy actions on expected future short-term rates (Peersman, 2002). At any point in time, investors’ best forecast as to the likelihood and magnitude of future policy actions is implicitly incorporated in the term structure of interest rates. This implies that information on anticipated future policy actions and their view of economic activity is contained in forward rates. As a result, changes in the Federal Reserve policy lead to an observed response in long-term rates which is partly dependent on how accurately investors have anticipated the policy action and partly on the revisions to the expected future policy actions. On one hand, if investors are surprised at the timing or the magnitude of policy change, the response of long-term interest rates may be larger, since policy actions lead to changes of market participants’ expectations of future policy actions (Moolman, 2002). On the other hand, if market participants anticipate policy action correctly, there is no need to revise their expectations in the future, and, thus, there may be little response of interest rates to the policy change.

Measuring Real Interest Rate

Gordon (1994) notes that the relationship existing between interest rates and monetary policy is based on the reasoning that modification of rates of interests is a type of monetary policy used by policy makers in a given economy with an aim of attaining desired outcomes. Both the interest rates and the monetary policies are macroeconomic policies generally affecting the overall development of a country.  In most instances, the central banks are the ones mandated to push the monetary policies. Hicks (2003) indicates that the aim of applying interest rate and monetary policy is largely determined by the outcomes expected by the apex bank. For instance, they may be applied in order to enable consumers to buy more services and goods, thus resulting to their improved general welfare. When central banks wish to reduce the economic activities in a country, it will be forced to raise the interest rate as well the consumers` expenditures in order to obtain the required finances to make the purchases. The bank may also tighten the prerequisites set for getting credit and loans. This will make it hard for the consumers to acquire loans from the financial institutions. Based on the above arguments, it is clear that there is need to measure interest rates, which will directly affect other monetary policies.

VIP support

VIP support services:
special attention is assured! $9.99 only!

Liquidity Effect View

Hicks (2003) argues that most of the central banks state their monetary policies in terms of the interest rates. For instance, in 2001, the ECB (European Central bank) indicated that it had failed to change its interest rates, due to the fact that the prevailing interest rates were viewed as consistent with maintenance of the stability of prices in medium term (Hicks, 2003). Later, the Central Bank of Brazil raised its interest rates due to the fact that the inflationary pressures were rising. Previously, the Federal Open Market Committee in the U.S. raised the target for federal fund rates aimed at creating balance in inflation rates. Despite the above practices, most of the central banks across the globe do not control the interest rates directly. They may target interest rates, but this can only be achieved if they adjust other instruments of control, like the supply of reserves. It is notable that all these instruments affect the stock of money, found in a given country. Further, finance market reactions to the supply of money are the key factors having direct effect to the interest levels. Hicks (2003) argues that economic theory gives two contradictory views of this kind of relationship. One of them follows from interaction of money supply and demand, and indicates that raising the interest rates, for instance, demands a reduction in money stock. As stipulated by this view, the demand for money is a decreasing function of nominal interest rate. This is due to the fact that interest rate is usually the opportunity cost of liquidity (holding cash). Therefore, any reduction in money supply must result to increase in interest rates, thus, being able to keep the existing money market at equilibrium.

Fisher Equation View

The other view is the one which follows the Fisher equation. It follows the reasoning that money and the interest rate are related positively. That is, by increasing the interest rate one ought to raise the rate of monetary growth. Gordon (1994) argues that Fisher Equation candidly states that nominal interest rate is equivalent the expected inflation rate plus real rate of interest. In instance where inflation-indexed securities are lacking, real interest rates may be computed through deflating nominal rate of interest. This is attained by measuring the expected inflation by employing Fisher equation given by

Want an expert to write a paper for you Talk to an operator now  

In this equation, r indicates the real interest rate while i indicates the nominal interest rate having the same maturity duration.  indicates the inflation rate that is expected for a similar duration being examined (Hicks, 2003). It is notable that the Fisher equation is enormously based on some restrictive assumptions. For example, there is omission of aspects touching on tax, although in practice, their impact is highly negligible. The equation also assumes that investors are usually indifferent as to whether investments they have made is real or nominal, provided the yield differentials are in line with the inflation expected. Unfortunately, if nominal interest rates are deflated by expected inflation this will result to data problems at another level as all the expectations are unobservable.

If the monetary policy fails to affect the real interest rate and the expected errors in the inflation are not considered, then the equation would imply that increased nominal rate is highly associated with raised inflation rates. Due to the fact that in the long run raised rates of inflation are linked with raised money growth rates, the equation suggests that increased interest rates demand an increased monetary growth rate. Gordon (1994) indicates that the measurement of interest rate is not a trivial as one is supposed to derive these rates from the prevailing market prices through areas like loan contracts or inflation-indexed bonds. These kinds of instruments are common in environments, having high inflation, and are easily found in countries, having low-inflations. However, in extremely developed economies only the United Kingdom offers a series spanning in a period of over five years. It is notable that the two views offer conflicting solutions as to how central banks ought to translate their interest rates targets into real changes in the supply of money. One views indicates that interest rates usually move in the opposite direction, while from the other view, they both move in the same direction.

Using the Future Rates in Gauging Policy Expectations

In the U.S., expectations of the Fed policy actions cannot be observed directly. Though future prices in the Fed funds are natural, there is a market-based proxy for the expectations. This kind of market was established at the CBT (Chicago Board of Trade) in 1989. Using future data as the measure of the expected, Fed policy has several advantages as compared to statistical proxies. First, there is no issue regarding selection of model. Second, the vintage of all the data employed in producing the forecast is not highly important. Further, there is no any challenge with generated regressor. The main disadvantage is due to the fact that it limits all the analysis to the post-1989 period.

Plagiarism check

Attractive plagiarism check option:
ensure your papers are authentic!

Explanatory Variables and Estimation Methodology

Artus & Barroux (1990) argue that the economic theory is very crucial in providing the guideline on what should be the real interest bearing. As a result, the approach that is appropriate in this study is the ad hoc, as it correlates the level of about five years and above. The result for the variables and their sources over the last fifty years can be obtained by using the following formulas in the table below.

Variables

  Description source
  1. Monetary variables (r3mre)
Three month real interest (nominal rate minus annual inflation over the last 12 months) BIS
  1. Fiscal variables

Nbg

 

 

 

 

Nbgca

 

 

 

Ggdgs

Net borrowing by general government, % of GPD (correspond to net lending in OECD database, Multiplied by -1)

 

Net lending by general government, cyclically adjusted, % of GDP

 

General government gross debt, % of GDP

OECD

 

 

 

 

 

 

OECD

 

 

OECD

  1. Control variables

Gdp_e5/10

 

 

Gdp

 

 

Y_gap

 

Unrte

 

Pi

 

 

Perat

 

 

 

 

comix

 

 

 

Real GDP growth expected over the next 5/10 years

 

The current GDP growth, 1960 prices

 

Output gap, % of GPD

 

Unemployment rate

 

Inflation over the previous 12 months

 

Price earnings ratio based on analysts’ forecast for profits of firms contained in MSCI country index in 12 months’ time

 

Competitiveness index, based on relative consumer prices

 

Consensus forecast

 

 

OECD

 

 

OECD

 

OECD

 

OECD

 

 

I/B/E/S

 

 

 

 

 

OECD

 

Empirical Evidence

To find the empirical evidence appropriate to the relationship between interest rates and monetary policy over the last fifty years, the study will present a cross-country case study, an investigation that will back up the Fisher Equation.  

The Fisher Equation View: A Positive Relationship

The Fisher equation has a positive view toward the relationship between interest rates and monetary policy. The proof that supports this view is generated mainly from relationships between two variables in the cross sections of nations. To scrutinize these data, the study begins by exploring the relationship of long-run averages for the two variables (Tseng & Corker, 1991). The main reason as to why this study is applying the long-run averages is due to the fact that quantity theory correlations between inflation and money growth, which is very significant connection between interest rates and monetary policy, appears empirically to support the long run and not the short run.  In other words, this means that the relation between inflation and growth of money is very strong as well as positive in the long run, but very weak in the short run. Therefore, it is obvious that the relationship between interest rates and monetary policy will be very strong in the long horizons data, when compared to the short horizons data, although still positive (Gupta & Moazzami, 1996).      

Proofreading service

Do you want your papers to be flawless?
Use our proofreading service!

The data applied is for cross sections of nations and not just one nation, so that the study will find credible results, which can be based on the relationship between the long run averages (Fabozzi, 2002). The data covered is from 1961 till now. For the growth rate of money, the study uses the series money, which is a measure that is used by the U.S M1 explanation of the money supply. When comes to the nominal interest rates, the study uses two series, money market rates (the rates on short term lending among financial institutions) and bond yields (the yields to ripeness of government bonds or other bonds that might have long run returns).  By applying the two series, the study reveals that the outcomes are not insightful to the mellowness of the nominal interest rate selected. The study can only compute nations that have data that covers a minimum of 14 years on monetary growth and interest rates (Gupta & Moazzami, 1996). As a result, the study conducted a random survey in both developed and developing countries, which qualified under this criterion, and here were the results:

Coefficient for Interest Rate Sample

Type of Measure Time Period Type of country Short-term: money market rates

Long-term: Government bond yields with Venezuela

Excluded

 

 

 

 

 

Included

Relationship coefficient Long run (1961-2011)

All

Developed

Developing

.71

.81

.62

 

.79

.70

.66

.87

.70

.84

  Short run 5-year periods (1964-98)

All

Developed

Developing

.52

.52

.49

.59

.50

.53

.68

.50

.69

 

1-year periods

(1961 - 98)

All

Developed

Developing

.24

.22

.23

.34

.26

.30

.41

.26

.41

Regression slope coefficient Long run (1961- 2011)

All

Developed

Developing

.68**

.68**

.66*

.60**

.56**

.51**

-

-

-

  Short run 5 years periods (1964-98)

All

Developed

Developing

.63**

.38**

.50**

.44**

.35**

.44**

-

-

-

           
           

Source:

The Liquidity Effect View: A Negative Relationship

After the rational prospects revolution of the 1970s, the economic theory has find out that an imaginable policy changes can take distinct bearing. Therefore, apart from viewing the effects of liquidity as just changes in the stock money, the contemporary studies have proved that there are other effects of expected and unexpected as well as variables (BeblavyÌ, 200). The study assumes that the liquidity effect is shock to money in addition to other variables. The shocks of monetary policy can come as a result of the choices of policymakers to amend it or errors made when making decisions. As noted from Gottschalk (2001), the recent study shows the liquidity effect of interest rates correlation, upbeat monetary policy shocks decreases the rates of interest and downbeat shocks increases them. 

The main aim of this paper was generally to shift debates on the real interest’s rates towards the long-term rates in the last fifty years. From the above study, one can clearly see that both the fiscal and monetary policy play a crucial role in determining real interest rates in the long-term, thus, having a close relationship toward each other. Given the fact that interest rates are important in long-run, it is clear that it influenced by the macroeconomic policy. Monetary policy is the stage, whereby the real interest rates in the short term become highly crucial. If the nominal rigidities are present, the real rates in the short run are placed under the control of the monetary policy. In contrast to the monetary policy, the fiscal policy mostly affects structure through changing demands for all loanable funds. Empirical work on the ex ante real rates of interests have suggested some real challenges.  The leading reason as to why there are little studies carried in this field is due to lack of data.  Nevertheless, the role played by the monetary policy has reduced since the late 1990s. In contrast to the monetary policy, there is no evidence outside Japan indicating that fiscal policy in a given country has become less crucial over time. Only in Japan there are low real interest rates coincided with high debt and government borrowing.

Silver member

5% OFF

Gold member

10% OFF

Platinum member

15% OFF

   

What Our Customers Say

Now Accepting Apple Pay!
Click here to chat with us