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Economics Of Banking Essay

1465 words - 6 pages

We observe very large and rapid declines in the policy rate (the very short rate) in late 2008 and early 2009. Considering the US, the UK, and Japan, did long rates fall as much around that time or less or more?

In late 2008, many developed economies where in or close to recession, with growth slowing noticeably in the emerging economies. These events prompted an easing of monetary policy and expansionary fiscal measures in many countries (Reserve Bank of Australia, 2008).

The policy rate is the target 'cash rate' set by central banks. This is also the market interest rate on overnight funds, which is used as an instrument for monetary policy (Mishkin, 2013). The long rate is also ...view middle of the document...

00% 0.25% 1.75%
UK 5.00% 0.50% 4.50%
Japan 0.50% 0.25% 0.25%
Avg. change 2.17

Long term rates
Country 2008 (Sep) 2009 (Mar) Decline
US 3.75% 3.00% 0.75%
UK 4.25% 3.50% 0.75%
Japan 1.75% 1.50% 0.25%
Avg. change 0.58

During a business cycle contraction, the goods and services being produced in the economy decrease. When this occurs, businesses will be less willing to borrow, because they will need to retain all funds to keep operations going. Interest rates tend to fall during recession, which is represented in graph 4.1. The demand for funds can help explain this fall in interest rates, as business retain funds instead of making investments (Mishkin, 2013).

When you compare the fall in long interest rates to the change in inflation expectations in these same three countries, did the real long rate stay the same or rise or fall during that period?

Workers and firms care about wages in real terms, that is, in terms of what wages can buy. When workers expect the price level, or inflation, to rise they will adjust nominal wages upwards with the rise in expected inflation. This is to ensure that the real wage rate does not decrease, allowing them to continue purchasing what they want (Mishkin, 2013).

During the period from late 2008 to early 2009, the expected inflation rate declined in accordance with the developments across the world. Comparing the fall in the long interest rate and the change in the expected inflation rate (Appendix 1, Graph 4.10), the long rate stayed the same during the period. Of the three countries in focus, the US was the only country whereby the long term rate and expected inflation rate did not move together.

Long term rates
Country 2008 (Sep) 2009 (Mar) Decline
US 3.75% 3.00% 0.75%
UK 4.25% 3.50% 0.75%
Japan 1.75% 1.50% 0.25%

Expected inflation
Country 2008 (Sep) 2009 (Mar) Decline
US 2.75% 2.50% 0.25%
UK 4.00% 3.25% 0.75%
Japan 2.50% 2.25% 0.25%

This can be explained by the Fisher effect, which states that when expected inflation falls, interest rate will fall (Mishkin, 2013)

The BIS Report shows estimates of expected inflation which are based on surveys. Use these estimates and combine them with actual nominal rates for 2013 (use the internet to find current values) to derive an estimate of the real long rate for the US, the UK and Japan in June of this year.

The nominal interest rate is the rate quoted that does not consider inflation. The rate that takes inflation into account is known as the real interest rate (Mishkin, 2013). The real interest rate is more accurately defined from the Fisher equation. The Fisher equation states that the nominal interest rate i equals the real interest rate r plus the expected rate of inflation π^e:

i = r + π^e

Rearranging terms, the real interest rate equals the nominal interest rate minus the expected inflation rate:

r = i - π^e

From graph 4.10 the data is as follows:

Expected inflation
US 2.25%

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