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

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  • How Canadians are affected by the rise in US interest rates
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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.

2. Outline the adverse selection and moral hazard problems that existed in the Euro crisis of 2009. (approx. 1.5 double spaced pages; 10 marks)

Before the Euro crisis of 2009, there are rules for the countries in the Eurozone to abide for which aim at avoiding moral hazards and the free-riding problem. The Stability Growth Pact of 1997 requires nations to agree on an annual deficit of 3% of GDP and a debt to GDP ratio of 60%. Furthermore, there will be no bailout clause for all countries. However, many members of the Eurozone have failed to comply with the Growth Path, which is the tip of the iceberg of the Euro crisis.

The worldwide ease of financial condition and converging Eurozone country interest rates also play a part in the moral hazard problem. Since there are no bailout clauses for each country, each country/bank will get a bailout if they have financial troubles, no matter how serious of a trouble they were in. Eventually, bailing out a member country or not punishing them encourages more moral hazard behavior as countries keep racking up on excessive capital flows with weak institutions. Moreover, these countries do not have sufficient regulation and monitoring to counter the moral hazard problem. All they can do is wait for the bailout to save them.

As for the adverse selection problem that the Eurozone has gotten themselves into, it started in 2007/2008 when the Euro banks are exposed to the CDOs/ toxic U.S mortgage backed securities. With the US facing a housing price bubble, the mortgage backed securities worth a lot less when compared at the time they were bought. At that time, the Euro banks didn’t know that the mortgage-backed securities were toxic, so they kept buying them. In the end of 2009, the European sovereign debt appears with larger than expected in debt to GDP ratios for Spain and Ireland. Greece also increased their deficit from 6% to 12%. With adverse selection, they failed to take advantage of the conditions that is favorable to them originally. The economy now is already in serious deficit a debt by the time they realize and the only thing they can do is wait for a bailout. This leads to the dilemma for the Eurozone on whether or not they should bail out Greece or any other countries because the cost for bailing them out is just too high.

Luckily, reform attempts such as the Fiscal Compact treaty requires written domestic legislation and has independent councils to monitor any moral hazard problems for each independent country. Sanctions will be applied if each country goes into a huge debt or deficit. The Banking Union also acts as a regulatory function and will inject equity to troubled banks to stabilize banking system. Lastly, the IMF will bail out troubled countries if they are in serious financial turmoil.

3. Explain the relationship between return on assets and return on equity. What incentives does this relationship give a bank manager? Is this the desired outcome preferred by regulators? Discuss. (approx. 1.5 double spaced page; 10 marks)

Return on assets(ROA) in the net profit after taxes per dollar of assets and it is also a measure of profitability of assets as well as how efficiently the bank is run. It can be calculated by (net profit after taxes)/assets. Return on equity(ROE) is the net profit after taxes per dollar of equity capital. It can be calculated by (net profit after taxes)/equity capital and is a measure for owners to see how they are doing on their investments. The relationship between ROA and ROE is the equity multiplier(EM) which is the leverage ratio. The EM is calculated by this formula: EM = Assets/Equity Capital. In words, it is the amount of assets per dollar of equity capital. Therefore, we can see that ROE = ROA x EM.

The equations and formulas will be summarized by the table below:

ROA (net profit after taxes)/assets net profit after taxes per dollar of assets

ROE (net profit after taxes)/equity capital the net profit after taxes per dollar of equity capital

EM Assets/equity capital leverage ratio

ROE = ROA x EM (net profit after taxes)/equity capital = (net profit after taxes)/equity capital x Assets/equity capital Relationship between ROE and ROA

This gives incentives for bank managers that they can increase the ROE by increase the equity multiplier, which is the leverage ratio. For a given level of ROA and assets, a lower level of equity capital increases the EM, therefore ROE will increase as a result. Bank managers may then earn more return on equity. However, regulators would not want the EM to increase because it would increase the risk of the inability of the bank to pay its debt. Bank capital is essential for the bank to avoid bankruptcy, but the amount of capital also affects the return of the owners of the bank. Therefore, it is difficult to maintain an equilibrium level of capital. Having an adequate amount of bank capital increases the capacity of the bank to earn more ROE but at the same time it increases the risk of the bank to go bankrupt. That’s why regulators would like a lower level of EM or a higher level of equity capital, to prevent the banks from going bankrupt once loans are defaulted. In the worse scenario or the extreme case of a bank having an extremely low level of equity capital, the EM will be very high and even a default of a small loan would cause the bank to go bankrupt. As a result, regulators in general would banks to hold more equity capital to prevent any insolvency from happening.

4. Describe the transaction the Bank of Canada makes when wanting to raise the overnight interest rate (6 marks). Also outline the effects on economic activity (the way monetary policy works) when the interest rate rises. (4 marks) (approx. 1.5 double spaced pages)

The Bank of Canada announces its target of the overnight interest rate on a Wednesday, the Bank of Canada can sell government bonds from the market through open market operations if wanting to the raise the overnight interest rate, but this method has been abandoned for T-bills since 1994. The Bank of Canada now uses the method of Sale and Repurchase Agreements (SRAs). For SRAs, the Bank of Canada will sell government bonds to the major financial institutions and banks and agrees to buy them back on the next day. The Market of Settlement Balances will then be negative for banks and financial institution because they bought the government bonds. The deposits of the banks and major financial institutions will fall because the buying of the government bonds counts as a debit in the settlement balances account. In order to make up for the lost in deposit and to bring the settlement balances account back to zero, the banks and financial institutions must borrow money in the money market. This in turn causes the overnight interest rate to rise because the bank of Canada is facing an excess demand of reserves. As a result, the Bank of Canada is ready to lend to the bank and financial institutions to bring their settlement balances back to zero. With the settlement balances back to zero at the end of the banking day, the operating band will shift up according to the increase in the overnight interest rate decided by the Bank of Canada. Noted that these transactions are done on the previous day of the announcement of the interest rate, therefore all the SRAs and the borrowings for the market of settlement balances are done on Tuesday, with the announcement of interest rate on Wednesday.

The Bank of Canada can also use the overnight interest rate as a monetary policy tool. When the interest rate rises, the Bank of Canada can control the level of economic activity through open market operations. By open market sales such as the selling of government bonds, the Bank of Canada is able the decrease the amount of money in circulation, shrink bank reserves and the monetary base. The short-term interest rate will rise, and the money supply will be lowered. Since the money supply is lowered, it is a contractionary monetary policy used to decrease the economic activity of the society.

The increased interest rate can affect the aggregate demand through the monetary transmission mechanism. First, the increased interest rate can lower the borrowing cost of the public, therefore consumption and investment demand will decrease. The spending of the economy will be less which leads to a decrease in the price level. Therefore, output will be lowered, and aggregate demand will be lowered as well. Secondly, the increased interest rate will influence capital flows and the exchange rate, in specific it will lead to increase in the value of Canadian dollars relative to the currencies of other countries. An appreciation of the exchange rate will cause net exports to decrease because exports are more expensive, and imports are cheaper. The spending of the economy will decrease, and output will be lowered accompanied with a decrease in the price level. These two channels will lead to a decrease in the aggregate demand and the level of economic activity will decrease.

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