Monday, November 4, 2019

Notes for after exam 1

CHAPTER 5: The Interest Rate

I- Interest Rates:
Market or Authority determined?
- In many Economies, Interest rates are market determined (Demand and Supply of
Money Market, Loan Market, Bond Market, etc..)
- In many economies, they are authority-determined. However, the authority
intervenes to keep the rate close to the market rate.

How do they keep it close?

The authority usually intervenes changing an authority-determined rate:

USA:
the Fed changes the discount rate and intervenes to change the federal funds rate accordingly
(through Open Market Purchase/Sale) and other interest rate follows (Here they say its market-
determined, Market forces are working)

The ECB:
(Check ECB website)
(New ECB president, Christine Lagarde she’s French, former minister of Eco and Finance in
France)
Here, the ECB changes 3 rates and other interest rates follow.
Website – Monetary Policy – Monetary Policy Decisions
- Key interest rate:
a- Deposit Facility and Marginal Lending Deposit: ECB receives/accepts overnight
(can be up to 3 days) credit (Deposit Facility) pays interest on them and makes
overnight Loans (Marginal Lending Deposit) and charges interest rate on them to
banks from the euro-system to meet requirements. The less the Deposit Facility
Rate the less likely banks will receives Credit (ECB does that so Bank can invest
the money in the economy). The CB to motivate the banks to deposit, they
increase the rate. And CB can lower Deposit rate to be able to lower the lending
rate thus motivating investments in a certain sector. (Ex, ECB Pays 2% interest
but receives 4.5% leaving them with a margin of 2.5%)
§ A negative deposit facility rate means the CB pays the bank for
putting their deposits in the CB. It is done also to discourage deposits
 and to motivate/stimulate the European economy (Price Stability less
than 2% and because inflation is so low now they can afford to
stimulate the economy more thus the negative rate)
b- Main refinancing Operations: Banks borrow from euro-system (CB) to create
loans and the CB charges banks a certain rate.

Lebanon:
High rates on LBP to discourage dollarization and encourage asset holdings in LBP.
High rates (but < LBP rates) on $ deposits to motivate (attract funds from abroad) funds to
Lebanon and prevent capital flight.
Rates became higher over the last years because of the pressure on LBP and on Lebanese
banking system
If rates on lira decrease subsequently incentives to hold lira will weaken (same for $)

Outside Note: when we privatize, we have to look at the following concerns:

1- which way does it happen? (selling shares or ??)
2– Price at which it happens?
3– the price of the fee after privatization, is it regulated by the gov or will it become a
monopoly?
4– what do we do with the proceeds of the Privatization, it’s a disaster if we close our
debt with it)

- Cost of Stable Lira: is the high interest rate used to stabilize the value of the lira
caused economic contraction. In other words, it is the cost we pay to protect the
value of LBP.

II- Real VS Nominal interest rates:

Real Rate = Nominal Rate - 𝜋 "

𝜋 " = expected inflation
The real rate determines investment activities. Thus, in Switzerland and Japan, nominal rates
are low or even negative because 𝜋 " is low.

Assume r(nominal) = -1%

If 𝜋 " = -0.5%
then real rate = r - 𝜋 " = -1 – (-0.5) = -0.5%
assume however 𝜋 " = -2%
real rate = -1 – (-2) = 1%

Accordingly, the higher the 𝜋 " the higher the real rate hence lower the investment activity.
- Deflation causes high unemployment.

III- Interest Rate, Country Risk and Currency Risk:

Country Risk:
for Lebanon = (Interest rate on a Lebanese T-Bill in USD (Eurobond)) – (Interest rate on US T-Bill
in $ for same maturity (risk-free rate))
§ The higher the difference, the higher the country risk.

When a country’s rates goes up against other countries rates, its country risk(‫)ﻣﺧﺎطر ﺳﯾﺎدﯾﺔ‬
measures go up. Also called sovereign risk.

Currency Risk:
Risk of LBP Vs $
(Int. rate on LBP T-Bill Issued by Lebanon) – (Int. rate on $ T-Bills issued by Lebanon)
for same Maturity

(Int. rate on LBP deposit) – (int. rate on $ deposit)

For same maturity