Interest rate and change in exchange rates
Central banks have several financial instruments to exercise monetary control. They are usually divided into three types: open market operations, the establishment of the required bank reserve ratio and the discount rate. Control over the supply of money in the national economy is carried out, as a rule, in order to stimulate economic growth in the country, or to protect the economy from overheating.
We will consider in detail the impact of the third type of financial instruments of the Central Bank – changes in the discount rate on changes in the exchange rate.
There is no need to look far for an example – the US Federal Reserve, concerned, among other things, with low rates of economic growth, until recently, has consistently reduced the interest rate for several years. Let us now consider what effect such a trend can have on the exchange rate of the national currency.
Let us make a digression about the term “discount rate”. In different countries, the official rate of the Central Bank is called differently, and the term “discount rate” is generalized and means the interest rate at which central banks issue loans to commercial banks.
Intuitively, one can make the assumption that a decrease in the discount rate should have a negative impact on the national currency rate and vice versa. Let’s get an informed confirmation of this guess using the economic model we are using.
First of all, let’s find out what will happen in the debt market as a result of the Central Bank’s discount rate cut.
Obviously, the demand for borrowed funds should not change. But the supply of borrowed funds should increase! This conclusion seems unclear and even dubious, since what is the link between the decrease in interest rates and the increased desire of the private sector to lend money. But let’s break it down in order.
The Central Bank cuts the discount rate. Commercial banks are starting to take loans from the Central Bank more willingly, thereby increasing their bank reserves. As a result, commercial banks have the opportunity to issue more loans (since their reserves have increased) at a lower interest rate (since the cost of credit resources from commercial banks decreased along with a decrease in the discount rate). This can only mean one thing – an increase in the supply of borrowed funds.
This question can be viewed from an alternative angle.
The government typically finances the budget deficit by borrowing money from the private sector, mainly through the sale of government securities. The profitability of these securities usually directly depends on the discount rate, that is, with a decrease in the discount rate of the Central Bank, the profitability of government securities issued into circulation should decrease, which should affect the amount of funds raised in this way. If less money is attracted to finance the budget deficit, then government spending should also decrease. Next, we follow the path discussed in the publication on the connection between the state budget deficit and changes in the exchange rate.
National savings (S) represent funds that remain after the payment of public expenses (G) and consumption costs ©. I.e,
S = Y – C – G
Reducing government spending (G) means increasing the left side of the equation, that is, savings. Savings, as we remember, represent an offer of borrowed funds.
Now let’s turn to the charts.
So, the decrease in the Central Bank’s discount rate led to an increase in the supply of borrowed funds. The debt supply curve in Figure 1 is shifting upward, that is, to the right.
As a result, we have a decrease in the real interest rate from r1 to r2. Reducing the interest rate allows potential investors to take out more loans to invest.
Let’s look at the next chart.
The real interest rate has dropped, which should make domestic assets less attractive for investment than foreign ones. This, of course, will lead to an outflow of capital abroad, as a result of which net foreign investment will increase.
Now, domestic investors will need more foreign exchange to acquire foreign assets, and, therefore, the supply of national currency in the foreign exchange market will increase. The supply line on the foreign exchange market chart shifts upward, i.e. to the right. As a result, the real exchange rate falls from Er1 to Er2. This is reflected in a proportional decrease in the nominal exchange rate of the national currency. The depreciation of the national currency, in turn, leads to a reduction in the cost of domestic goods relative to foreign ones, which leads to an increase in exports and a decrease in imports, and, consequently, to an increase in the trade balance (net exports).
So, our initial assumption turned out to be correct – a decrease in the Central Bank’s discount rate should really become a factor contributing to a decrease in the national currency rate.
I propose to find confirmation of this conclusion independently by comparing the dynamics of the main exchange rates and the dynamics of interest rates of the respective countries.
Interest rate and exchange rate dynamics during the financial crisis
However, will there always be a direct relationship between the Central Bank’s discount rate and the dynamics of the exchange rate. Not at all. For confirmation, let’s look at an example from modern Russian history.
Since the beginning of 1998, a crisis has been brewing in the system of refinancing the state budget deficit by issuing GKOs. This was reflected in the rapid growth of the refinancing rate, which at some point reached the level of 150%. As a result, when the government announced a default, the ruble’s exchange rate against the US dollar simply collapsed, dropping more than three times in a few months.
Now let’s look at the current situation from the point of view of our model.
The financial crisis caused a massive outflow of foreign investment from Russia, which led to an increase in net foreign investment. The net foreign investment curve shifted upward, that is, to the right.
The growth of foreign investment is causing an increase in the demand for borrowed funds needed to finance these investments. To make this conclusion clearer, I will explain using the example under consideration. It has become profitable for domestic investors (for example, Russian citizens) to borrow money in rubles in order to simply transfer it into dollars. And the acquisition of foreign currency (in this case dollars) is nothing more than foreign investment.
As a result, the real interest rate rises from r1 to r2.
At the same time, the supply of the national currency in the foreign exchange market will increase. The supply line on the foreign exchange market chart shifts upward, i.e. to the right. As a result, the real exchange rate falls from Er1 to Er2. This is reflected in a proportional decrease in the nominal exchange rate of the national currency.
In fact, we have an increase in the Central Bank’s discount rate while the national currency depreciates.
A political crisis will give approximately the same effect, since in this case there will also be a “capital flight” from the country.
Now we can summarize. In most cases, the change in the Central Bank’s discount rate is directly related to the dynamics of the national currency rate. The exceptions are situations when there are economic or political crises and the associated “capital flight” from the country. In this case, an increase in the interest rate will be accompanied by a fall in the exchange rate of the national currency.