INTEREST RATES, EXCHANGE RATES AND INFLATION : THEORY AND FORECASTING GÖKBERK CAN

INTEREST RATES, EXCHANGE RATES AND INFLATION : THEORY AND FORECASTING

GÖKBERK CAN

INTEREST RATES IN THE FINANCIAL SYSTEM The price of acquiring credit, usually expressed as a ratio of the cost of securing credit to the total amount of credit obtained. The rate of interest is really a ratio of two quantitites: the money cost of borrowing divided by the amount of money actually borrowed.

The price of acquiring credit, usually expressed as a ratio of the cost of securing credit to the total amount of credit obtained.

The rate of interest is really a ratio of two quantitites: the money cost of borrowing divided by the amount of money actually borrowed.

THE CLASSICAL THEORY OF INTEREST RATES Developed during the 18 th and 19 th centuries by a number of British economists and elobrated by Irving Fisher (1930). The classical theory argues that the rate of interest is determined by two forces The supply of savings, derived mainly from households The demand for investment capital, coming mainly from business sector

Developed during the 18 th and 19 th centuries by a number of British economists and elobrated by Irving Fisher (1930).

The classical theory argues that the rate of interest is determined by two forces

The supply of savings, derived mainly from households

The demand for investment capital, coming mainly from business sector

THE LIQUIDITY PREFERENCE THEORY OF INTEREST RATES Developed by Keynes in 1936. The theory is also known as Cash Balances Theory. Keynes argued that the rate of interest is really a payment for the use of scarce resource, money . Interest rates are the price that must be paid to induce money holders to surrender a perfectly liquid assset and hold other assets that carry more risk.

Developed by Keynes in 1936. The theory is also known as Cash Balances Theory.

Keynes argued that the rate of interest is really a payment for the use of scarce resource, money .

Interest rates are the price that must be paid to induce money holders to surrender a perfectly liquid assset and hold other assets that carry more risk.

THE LOANABLE FUNDS THEORY OF INTEREST The credit view of what determines the level of and changes in interest rates that focuses on the interaction of the demand for and the sıpply of loanable funds. The demands are made by consumers, domestic business, goverment and foreigners. The supply is done by the domestic savings, dishoarding of money balances, creation of credit by the domestic banking system and foreign lending.

The credit view of what determines the level of and changes in interest rates that focuses on the interaction of the demand for and the sıpply of loanable funds.

The demands are made by consumers, domestic business, goverment and foreigners.

The supply is done by the domestic savings, dishoarding of money balances, creation of credit by the domestic banking system and foreign lending.

THE RATIONAL EXPACTATIONS THEORY An explanation of the level of and changes in interest rates based on changes in investor expactations regarding future security prices and returns. The theory argues that forecasting interest rates requires knowledge of the public's current expactations. If new information is sufficient to alter those expactations, interest rate must change.

An explanation of the level of and changes in interest rates based on changes in investor expactations regarding future security prices and returns.

The theory argues that forecasting interest rates requires knowledge of the public's current expactations.

If new information is sufficient to alter those expactations, interest rate must change.

MEASURES OF THE RATE OF RETURN, OR YIELD, ON A LOAN OR SECURITY Coupon Rate : The promised interest rate on a bond or note consisting of the ratio of the annual interest income promised by the issuer to the security’s face/par value. Formula : Coupon Rate x Par Value = Coupon Current Yield : The ratio of a security’s promised or expected annual income to its current market price. Formula :

Coupon Rate : The promised interest rate on a bond or note consisting of the ratio of the annual interest income promised by the issuer to the security’s face/par value.

Formula : Coupon Rate x Par Value = Coupon

Current Yield : The ratio of a security’s promised or expected annual income to its current market price.

Formula :

MEASURES OF THE RATE OF RETURN, OR YIELD, ON A LOAN OR SECURITY (cont.)‏ Yield to Maturity : The rate of the interest the market is prepared to pay for a financial asset to exchange present for future. Formula : Holding Period Yield : The rate of return of recieved or expected from a loan or security over the period the investor actually hold it. Formula :

Yield to Maturity : The rate of the interest the market is prepared to pay for a financial asset to exchange present for future.

Formula :

Holding Period Yield : The rate of return of recieved or expected from a loan or security over the period the investor actually hold it.

Formula :

FACTORS AFFECTING INTEREST RATES Marketability : The feature of a loan or security that reflects its ability to be sold quickly to recover the purchaser’s funds. Liquidity : The quality or capability of any asset to be sold quickly with little risk of loss and possessing a relatively stable price over time Default Risk : The risk to the holder of debt securities that a borrower will not meet all promised payments at the times agreed upon.

Marketability : The feature of a loan or security that reflects its ability to be sold quickly to recover the purchaser’s funds.

Liquidity : The quality or capability of any asset to be sold quickly with little risk of loss and possessing a relatively stable price over time

Default Risk : The risk to the holder of debt securities that a borrower will not meet all promised payments at the times agreed upon.

EXCHANGE RATES The price of one currency in terms of another is called exchange rate. Transcations conducted in the foreign exchange market determine the rate at which currencies are exchanged, which in turn determine the cost of purchasing foreign goods and financial assets. The increase of a currency is appreciation , the fall is depreciation .

The price of one currency in terms of another is called exchange rate.

Transcations conducted in the foreign exchange market determine the rate at which currencies are exchanged, which in turn determine the cost of purchasing foreign goods and financial assets.

The increase of a currency is appreciation , the fall is depreciation .

TYPES OF EXCHANGE RATES Nominal exchange rates, which are reported daily in newspapers worldwide, are based on currency financial markets called forex markets. Real exchange rates are nominal exchange rates corrected by an inflation measure. Bilateral exchange rates are figured by comparing two countries’ currencies. Multilateral exchange rates are figured by comparing multiple currencies.

Nominal exchange rates, which are reported daily in newspapers worldwide, are based on currency financial markets called forex markets.

Real exchange rates are nominal exchange rates corrected by an inflation measure.

Bilateral exchange rates are figured by comparing two countries’ currencies.

Multilateral exchange rates are figured by comparing multiple currencies.

TRADE OF EXCHANGE RATES The foreign exchange market is organized as an over-the-counter market in which several hundred dealers stand ready to buy and sell deposits in denominated in foreign currencies. Spot transaction: The immediate (two-day) exchange of bank deposits. Forward transactions: The exchange of bank deposits at some specified future date.

The foreign exchange market is organized as an over-the-counter market in which several hundred dealers stand ready to buy and sell deposits in denominated in foreign currencies.

Spot transaction: The immediate (two-day) exchange of bank deposits.

Forward transactions: The exchange of bank deposits at some specified future date.

EXCHANGE RATES IN THE SHORT RUN To understand the short-run behavior of exchange rates is to recognize that an exchange rate is the price of domestic bank deposits in terms of foreign bank deposits. Comparing Expected Return on Domestic and Foreign Deposits Interest Parity Condition

To understand the short-run behavior of exchange rates is to recognize that an exchange rate is the price of domestic bank deposits in terms of foreign bank deposits.

Comparing Expected Return on Domestic and Foreign Deposits

Interest Parity Condition

EXCHANGE RATES IN THE SHORT RUN (cont.)‏ Expected Return on Domestic and Foreign Deposits : The most important factor affecting the demand for domestic/foreign deposit is expected return on these assets relative to each other. Interest Parity Condition : It states that the domestic interest rate equals the foreign interest rate minus the expected appreciation of the domestic currency.

Expected Return on Domestic and Foreign Deposits : The most important factor affecting the demand for domestic/foreign deposit is expected return on these assets relative to each other.

Interest Parity Condition : It states that the domestic interest rate equals the foreign interest rate minus the expected appreciation of the domestic currency.

EXCHANGE RATES IN THE LONG RUN Law of One Price: If two countries produce an identical good, and transportation costs and trade barriers are very low, the price of the good should be throughout the world. Theory of Purchasing Power Parity: Exchange rates between any two currencies will adjust to reflect the changes in the price level of two countries.

Law of One Price: If two countries produce an identical good, and transportation costs and trade barriers are very low, the price of the good should be throughout the world.

Theory of Purchasing Power Parity: Exchange rates between any two currencies will adjust to reflect the changes in the price level of two countries.

EXCHANGE RATES IN THE LONG RUN (cont.)‏ Factors that affect exchange rates in the long run: Relative price levels Trade barriers Preference for domestice vs. foreign goods Productivity

Factors that affect exchange rates in the long run:

Relative price levels

Trade barriers

Preference for domestice vs. foreign goods

Productivity

EXPLAINING CHANGES IN THE EXCHANGE RATES Changes in the foreign interest rate : An increase in the foreign interest rate shifts the foreign deposit schedule to the right and causes the domestic currency to depreciate. Changes in the expected future exchange rate : A rise in the expected future exchange rates shifts the foreign deposit schedule to the lef and causes an appreciation of the domestic currency.

Changes in the foreign interest rate : An increase in the foreign interest rate shifts the foreign deposit schedule to the right and causes the domestic currency to depreciate.

Changes in the expected future exchange rate : A rise in the expected future exchange rates shifts the foreign deposit schedule to the lef and causes an appreciation of the domestic currency.

INFLATION A rise in the average level of prices for all goods and services traded in economy over any given period of time. "Inflation is always and everywhere a monetary phenomenon." Milton Friedman Whenever a country's inflation rate is extremely high for a sustained period of time, its rate of money supply growth is also extremely high.

A rise in the average level of prices for all goods and services traded in economy over any given period of time.

"Inflation is always and everywhere a monetary phenomenon." Milton Friedman

Whenever a country's inflation rate is extremely high for a sustained period of time, its rate of money supply growth is also extremely high.

THE NOMINAL AND REAL INTEREST RATES Nominal interest rate: the published rate of interest attached to a loan or security that includes both a real interest rate and the inflation rate/premium expected over the life of the security or loan. Real interest rate: The rate of return from a financial asset expressed in tems of purchasing power. (adjusted for inflation)‏ Inflation premium: The expected rate of price inflation that, when added to the real interest rate, equals the nominal interest rate on a loan.

Nominal interest rate: the published rate of interest attached to a loan or security that includes both a real interest rate and the inflation rate/premium expected over the life of the security or loan.

Real interest rate: The rate of return from a financial asset expressed in tems of purchasing power. (adjusted for inflation)‏

Inflation premium: The expected rate of price inflation that, when added to the real interest rate, equals the nominal interest rate on a loan.

THE NOMINAL AND REAL INTEREST RATES – The Fisher Effect Inflation premium: The expected rate of price inflation that, when added to the real interest rate, equals the nominal interest rate on a loan. NIP = Expected Real Rate + Inf. Premium + (Exp. Real Rate x Inflation Premium)‏ Fisher Effect argues that nominal interest rates respond one-for-one to changes in the expected rate of inflation over the life of a loan.

Inflation premium: The expected rate of price inflation that, when added to the real interest rate, equals the nominal interest rate on a loan.

NIP = Expected Real Rate + Inf. Premium + (Exp. Real Rate x Inflation Premium)‏

Fisher Effect argues that nominal interest rates respond one-for-one to changes in the expected rate of inflation over the life of a loan.

INFLATION AND STOCK PRICES Does inflation cause the prices of corporate stock (equities) to rise? Yes? A rise in expected inflation raises stock prices, it will increase the amount of dividends shareholders expect each company to pay them or lower the perceived risk of holding stock or both.

Does inflation cause the prices of corporate stock (equities) to rise? Yes?

A rise in expected inflation raises stock prices, it will increase the amount of dividends shareholders expect each company to pay them or lower the perceived risk of holding stock or both.

INFLATION-ADJUSTED SECURITIES TIPS: Treasury Inflation Protection Securities The inflation measure used to adjust the investors’s return from TIPS is the Consumer Price Index. (CPI)‏ TIPS* = Original Face Value + [1+Annual Rate Of Inflation] Time to maturity in years *: inflation-adjusted nominal value to maturity

TIPS: Treasury Inflation Protection Securities

The inflation measure used to adjust the investors’s return from TIPS is the Consumer Price Index. (CPI)‏

TIPS* = Original Face Value + [1+Annual Rate Of Inflation] Time to maturity in years

*: inflation-adjusted nominal value to maturity

APPROACHES TO FORECASTING INTEREST RATES Money Supply Liquidity Effect : Increases/Decreases in the money supply causing interest rates to move in the opposite direction. Money Supply Expectations Effect : Compares actual growth of the money supply with the market’s expectation for money supply. Money Supply Income Effect : Increases and decreases in income and spending resulting in changes in the demand for money, and leading to corresponding increases and decreases in interest rates.

Money Supply Liquidity Effect : Increases/Decreases in the money supply causing interest rates to move in the opposite direction.

Money Supply Expectations Effect : Compares actual growth of the money supply with the market’s expectation for money supply.

Money Supply Income Effect : Increases and decreases in income and spending resulting in changes in the demand for money, and leading to corresponding increases and decreases in interest rates.

APPROACHES TO FORECASTING INTEREST RATES (cont.)‏ Econometric Models : The use of systems of equations and statistical estimation methods to explain or forecast changes in interest rates or other variables. Implied Rate Forecasting : The expectation about future interest rates as indicated by the shape of the yield curve or by financial futures prices. Consesus Forecast : A prediciton of interest rates based on a variety of projections derived from several different forecasting methods.

Econometric Models : The use of systems of equations and statistical estimation methods to explain or forecast changes in interest rates or other variables.

Implied Rate Forecasting : The expectation about future interest rates as indicated by the shape of the yield curve or by financial futures prices.

Consesus Forecast : A prediciton of interest rates based on a variety of projections derived from several different forecasting methods.

FORECASTING INFLATION An inflation target is a numerical point or range for the inflation of a given price index that the central bank declares to be its objective for inflation. A major virtue of quantified inflation objectives is to anchor inflation expectations—a key ingredient for the success of monetary policy If inflation and expectations have become better anchored, they will be less sensitive to news on the state of the economy, because the public expects the central banks to act to keep inflation stable.

An inflation target is a numerical point or range for the inflation of a given price index that the central bank declares to be its objective for inflation.

A major virtue of quantified inflation objectives is to anchor inflation expectations—a key ingredient for the success of monetary policy

If inflation and expectations have become better anchored, they will be less sensitive to news on the state of the economy, because the public expects the central banks to act to keep inflation stable.

EUGENE F. FAMA – Short Terms Interest Rates as Predictors of Inflation HILDE C. BJØRNLAND AND HÅVARD HUNGNES – The Importance of Interest Rates for Forecasting the Exchange Rate THE ARTICLES

EUGENE F. FAMA – Short Terms Interest Rates as Predictors of Inflation

HILDE C. BJØRNLAND AND HÅVARD HUNGNES – The Importance of Interest Rates for Forecasting the Exchange Rate

Fama suggets, if the inflation rate is to some extent predictable, in the efficient market, between one period nominal interest rate observed at a point in time and the one period of inflation subsequently observed, there will be relationship. A constant expected real return implies that all variation through time in the nominal rate is direct reflection in the market assessment of the expected value of random time. FAMA – SHORT TERM INTEREST RATES AS PREDICTORS OF INFLATION

Fama suggets, if the inflation rate is to some extent predictable, in the efficient market, between one period nominal interest rate observed at a point in time and the one period of inflation subsequently observed, there will be relationship.

A constant expected real return implies that all variation through time in the nominal rate is direct reflection in the market assessment of the expected value of random time.

During 1953-71, the bond market seems to be efficent in the sense that in setting one-to-six month nominal rates of interest. Equilibrium expected real returns on one-to-six month bills are constant during this period. All variation through time in one-to-six month nominal rates of interest mirrors variation in correctly assessed one-to-six month expected rates in purchasing power. FAMA – SHORT TERM INTEREST RATES AS PREDICTORS OF INFLATION

During 1953-71, the bond market seems to be efficent in the sense that in setting one-to-six month nominal rates of interest.

Equilibrium expected real returns on one-to-six month bills are constant during this period.

All variation through time in one-to-six month nominal rates of interest mirrors variation in correctly assessed one-to-six month expected rates in purchasing power.

v t =p t -p t * and r t =v t -p t +p t * If PPP is valid, the real exchange rate is stationary and fluctuates areound a fixed value in the short run. On the long-run PPP, either rejected due PPP follows a stationary process or by suggesting that the real exchange rate adjust too slowly in the long run equilibirum rate to be consistent with traditional PPP. BJØRNLAND&HUNGNES - The Importance of Interest Rates for Forecasting the Exchange Rate

v t =p t -p t * and r t =v t -p t +p t *

If PPP is valid, the real exchange rate is stationary and fluctuates areound a fixed value in the short run.

On the long-run PPP, either rejected due PPP follows a stationary process or by suggesting that the real exchange rate adjust too slowly in the long run equilibirum rate to be consistent with traditional PPP.

The forecasts are generated at one, two, three and four quarters. These horizons are common in the literature and correspond well with the duration of standard forward contracts. In the next step, the estimation period is rolled forward by one quarter, keeping the total length of the estimation period (15 years) fixed. New forecasts are then generated at one, two, three and four quarters, and so on. In the end, the squares of the fore cast errors at the different horizons are averaged using the root mean square error and the mean absolute error. BJØRNLAND&HUNGNES - The Importance of Interest Rates for Forecasting the Exchange Rate

The forecasts are generated at one, two, three and four quarters. These horizons are common in the literature and correspond well with the duration of standard forward contracts.

In the next step, the estimation period is rolled forward by one quarter, keeping the total length of the estimation period (15 years) fixed. New forecasts are then generated at one, two, three and four quarters, and so on.

In the end, the squares of the fore cast errors at the different horizons are averaged using the root mean square error and the mean absolute error.

A parsimonious dynamic exchange rate model for Norway that combines the purchasing power parity condition with the interest rate differential in the long run can outperform a random walk model in an out-of-sample forecasting exercise. The results emphasize the importance of the interest rate differential in the long run whenpredicting exchange rate behaviour, as in no case does a pure PPP model outperform any other model. BJØRNLAND&HUNGNES - The Importance of Interest Rates for Forecasting the Exchange Rate

A parsimonious dynamic exchange rate model for Norway that combines the purchasing power parity condition with the interest rate differential in the long run can outperform a random walk model in an out-of-sample forecasting exercise.

The results emphasize the importance of the interest rate differential in the long run whenpredicting exchange rate behaviour, as in no case does a pure PPP model outperform any other model.

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