Essay: How Canadians are affected by the rise in US interest rates

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  • Subject area(s): Economics essays
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  • Published on: January 9, 2019
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1. Find a recent (Jan. 1, 2018‐present) money and banking related article in the media

(the Economist, Globe and Mail, National Post, New York Times, etc.,), and attempt to

explain parts or all of it using the tools we learned in class. Highlight the sentences that

you analyze, and hand in the article along with your work. Use written and graphical

explanations. (approximately 3 double spaced pages; 20 marks)

The article talks about how Canadians are affected by the rise in US interest rates. I’ll analyze some parts of the article in the following paragraphs.

Pittis (2018) mentioned that market participants are confident that the US will raise the federal funds rate from 1.5 to 1.75 percent. The rise of the US. Federal funds rate from 1.5 to 1.75 percent equals to an increase in the overnight interest rate, the rate at which banks and financial institutions loan to each other in the money market. It does so by a lot of mechanisms such as the Sale and Repurchase Agreements, which the Central Bank of the U.S sells government bonds to major financial institutions and banks and agrees to purchase them back the next day. As a result the deposits of banks and financial institutions will be debited and they have to borrow the money from the Central bank in order bring the settlement balances back to zero. The operating band will then shift up and the federal funds will increase. Here’s a graphical illustration of the shifting up of the operating band:

Figure 1. The Operating Band

The increase in the federal funds rate will lead to a decrease in the aggregate demand because consumption and investment demand has decreased, as well as a reduction in net exports. This can also be a result of the contractionary monetary policy if the U.S engage in open market operations such as the selling of the government bonds, which would lead to a decrease in the monetary base as well as the money supply. Here’s a graphical explanation on how the reduction in money supply affects interest rates and economic output:

Figure 2. Money Supply and Interest Rates

The decrease in money supply shifts the money supply curve to the left, and the equilibrium interest rates increases.

Figure 3. Aggregate output and Price Level

The increase in interest causes a decrease in consumption and investment spending, as well as net exports. Therefore, the aggregate demand level is lowered and the AD curve shift to the left. The leftward shift of the AD curve causes the price level and economic output to decrease.

The effect on Canadians for the increase in federal funds rate is also significant. In the article, it mentioned that importing inflation will be one of the phenomenon and will act as a warning for rising interest rates in Canada.(Pittis, 2018) If the Canadians expected that the increase in the US federal funds rate will bring imported inflation to Canada, it will affect both the Canadian economy and its bonds and securities market. The expected inflation will decrease the demand for bonds and increases the supply of bonds. The equilibrium price of bonds will decrease and the quantity of bonds should remain the same. Here’s a graphical explanation on the effect of the increase in expected inflation on the bond markets:

Figure 4. Expected Inflation on Bond Markets

Not only does it affect the equilibrium price of bonds, the interest rate will increase due to the increase in the price of bonds from the Fisher effect. The Fisher effect states that nominal interest rates = real interest rates + expected inflation. The increase in expected inflation will cause an increase in nominal interest rates. As a result, the cost of borrowing from the Canadians will rise, which could lead to a lower consumption and investment demand, then aggregate demand will decrease. Economic output will be lowered as well.

The article also mentioned that “ long-term path of interest rates in coming years would be higher than otherwise expected”.(Pittis,2018) This is true according to the expectations theory. As explained from the above paragraph, the short term interest rate has risen due to the increase of the rate of expected inflation. Therefore, when the short term interest rates increases, the long term interest rates of bonds should also increase according to the expectations theory. The expectations theory states that the long term interest rate of a bonds equals to the average of the short term interest rates of the bond, thus when each of the short term interest rates increases, the average of the short term interest rates also increases. The long term interest rate will be higher than before eventually. Knowing that the short term interest rates are high, we know that the yield curve of bonds slopes upwards from the liquidity premium theory. A steeply upward sloping yield curve tells us that the market are expecting the short term interest rate will increase in the future, which arrives the same conclusion with the news article. The long term interest rate should rise higher than what people has expected. Below is a graphical illustration of a steeply upward sloping yield curve:

From the article, we can see that the economy of Canada and the US are interconnected. Any determinants of one economy will undoubtedly affect the other economy as well. For example, an increase in the federal funds rate in the U.S may seem unrelated to the Canadian economy, but in fact the Canadian economy will be affected in a lot of aspects. Therefore, we should not undermine the effect of changes in the interest rate of other economies.

Reference:

Pittis, D. (2018) Heavily indebted Canadians need to watch U.S. interest rate announcement. CBC News Retrieved from: http://www.cbc.ca/news/business/us-fed-interest-rates-canada-1.4567900

News article and the graphical illustrations will be attached in the end of this assignment.

Sentences that I analyzed were highlighted in orange.

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