i was wondering what the general view of the reaction to exchange rates is when interest rates are changed. the bank of england page stated and increase in the interest rate would rise asset values in england and encourage purchasing pounds and strengthen the pound. it also said it is an area of much debate and is not always in following with the expectations.
what is your opinion?
If there are any FOREX traders here then maybe they can shed different light than what I'm about to say. Those guys consider this type of stuff all the time.
Increasing interest rates would rise asset values in England? Don't think so. What is interest rate? The natural interest rate is set by people's time preference. However, the going interest rate is artificially regulated by the central bank by removing some of the money & credit from the system. Raising rates makes money more scarce and therefore more effort to get it. A higher interest rate means money you hold today can buy more in the future, the more the longer you hold onto it. Therefore, things in the future require less effort, priced in today's dollars, because those dollars will appreciate with interest over time. A high interest rate also means that someone who wants something now who borrows now will have to pay more for it. Interest on the debt is the premium he pays to 'get it now' versus waiting to save and buy it later when he has the money. Higher interest rates would promote locals to not borrow to buy now, but prefer to save and buy later. Later will come sooner because interest grows their money pile faster, and you pay less for the item (in the long run) than you do by paying cash today or borrowing and paying an interest premium to get it today. So your question / Gordon Brown's claim is this: will asset prices go up with rising interest rates? Well, will people prefer to own assets or money (to save their money) if interest rates go up? Consider this: if you can afford $1000/month mortgage payment then you can afford a $165,000 mortgage at 6% interest. Or if interest rates rise to 7% you can only afford $149,000 house. The purchase price for that house had to fall 10% to make the same affordability considering a 1% rise in interest rate. If people's time preference had gone up (willing to pay the premium) then they would be willing to pay the $1100/mo at the 7%. Will Gordon Brown's increased interest rate change people's time preference?
As for people wanting to purchase pounds and driving up the exchange rate, yes raising rates may do that. But there are other forces that set the exchange rate besides interest rate. Yes, if my American bank has has 0.5% interest rate, if I open up a British bank account and buy pounds then it my pounds may grow at 4% interest in England. But I don't think enough people will do this to affect the rate. What about Britain's export market? One of their biggest exports is their North Sea oil. This oil source is in decline and soon Britain won't be exporting anymore. When you dig something out of your ground and you sell it to some other country Britain receives American dollars which they use to buy/exchange against their pounds. That drives up the exchange rate for the pound compared to the US dollar. If other currencies referenced to US dollars stay the same then the pound appreciates against all other currencies. This is because they are creating & exporting something that the rest of the world wants, and customers need to directly or indirectly obtain British pounds in order to buy from England. I believe this has more dominance in driving the exchange rate of British pound than say boosting interest rates to get people to put their savings in the bank of England. Another thing, as people put more money in the bank of England, or save more money, this should drive down interest rates again. As a surplus of savings build, the demand to borrow goes down but the supply which to borrow goes up. Therefore interest rates should only go down until more people start to borrowing more to even out supply & demand for money.
Another thing, if you have a weak economy that relies on low interest rates to be profitable or to keep prices propped up, if you raise rates you can create economic slow down. People prefer to save money rather than buy goods, so the price of goods has to fall if there is any surplus supply that must be liquidated.
I believe interest rates vary based on three things: 1) speculation of future valuation/purchasing power of the currency - related to inflation 2) The amount of future exports that country will be producing and 3) the stability and faith in the government to make decisions to benefit the economy or to honestly control the money supply. There's probably more. I just can't think of them right now. If you go on a FOREX website and do a tutorial - it will teach you some things about exchange rates.
Long term, the exchange rate between two currencies should depend on the purchasing power of the money in each country. This would be an equilibrium condition. This is determined by inflation - how much money the central bank has printed & put in circulation. Say in the USA bread costs $1 but in Canada it costs $1.50 and say the exchange rate between Canada:US is 2:1. There is an imbalance. It is more profitable for Canada to export its bread to the USA and get $1USD, use it to buy Canadian money to get $2CDN. If many products have such price imbalances, Canada will export them and this will strengthen $CDN against $USD until such profitability is lost. This happens when the exchange rate becomes 1.5:1
I didn't read the whole of the previous post but the key point is this:
The interest rate the CB sets is only the interest rate at which the CB lends to other banks - and this makes up a small percentage of total credit and lending in the economy. Thus, it will have little effect on hot money, which is looking for the effective interest rate to be high. If the government taxed in a lot of money, then burnt it (decreased the money supply), then they would increase effective real interest rates, causing hot money flows, and exchange rate appreciation. This is all taking fiat currency as an assumption, remember.
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