| | | | | | | Curiosity 18.1: Can Monetary Policy Change Real Interest Rates? | | | | | | | | | | Interest rate parity suggests that the world real interest rate is determined by major countries like the United States and that smaller countries such as Canada are forced to have a real interest rate equal to this world real interest rate plus a risk premium. An implication of this statement is that Canadian monetary policy should not be able to affect the gap between the Canadian and U.S. real rates and thus unilaterally change the Canadian real interest rate. However, central banks do raise and lower their real interest rates to affect their exchange rate, at least temporarily once again confirming the maxim that interest rate parity should be interpreted as an approximate relationship holding over the long run. | | | | | | | | | | Suppose that the real interest rate in Canada rises to make the difference between Canadian and U.S. real interest rates greater than the Canada/U.S. risk premium. Investors hold diversified wealth portfolios consisting of optimal fractions Of assets with different risk/yield combinations. When the Canadian yield moves higher, the optimal fraction of Canadian bonds in investor portfolios rises slightly, so investors adjust their portfolios to hold more Canadian bonds. The operative word here is "slightly": they are not willing to buy massive quantities of the Canadian bonds because doing so would raise the overall risk of their portfolio beyond what the higher yield on Canadian bonds warrants. Consequently, although the rise in the Canadian real interest rate is curtailed by extra foreign purchases of Canadian bonds, it is not eliminated. | | | | | | | | | | In addition, the activity of buying these bonds creates a demand for Canadian dollars that bids up the value of the Canadian dollar beyond the level that many would consider to be normal. As a result, investors may think that the Canadian dollar is more likely to fall in the future and thus may consider Canadian bonds as being riskier than before the interest rate rose. Consequently, the rise in the value of the Canadian dollar also limits the quantity of extra bonds bought by foreigners, preventing the Canadian real rate from falling back to its original level. | | | | | | | | | | A determined central bank can modestly increase its real interest rate above that of the "world" real rate, beyond the risk premium, thereby creating a continuing capital inflow. The capital inflow will initially be quite large, as investors readjust their portfolios, but then will fall off to a modest level that reflects a higher fraction of the flow of new saving. A policy of keeping the real interest rate above the world rate, such as that followed by the United States during the 1980s because of budget deficits and low savings rates, causes foreign debt (U.S. bonds owned by foreigners) to increase, something that cannot go on forever. Interest rate parity is consequently a better guide to long-run than short-run behavior. | | | | | |
| | | | | fected by financial activity in these other large countries. The forces described in our Canadian example come about because the Canadian financial market is quite small relative to the U.S. market. If the Canadian and other small markets were microcosms of the U.S. market, the rate prevailing in the U.S. market would undoubtedly also prevail in these smaller markets. They are not exactly the same as the U.S. market, however, if for no other reason than that they are located in another country, with bonds denominated in another currency. The U.S. market sets a standard, not just in terms of a numerical rate, but also in terms of the institutional structure associated with its financial transactions. Investing in a U.S. bond carries with it an implicit degree of riskiness, associated with the political stability, market | | | | |
