Question

Diagram the effect of each of the following on U.S interest rates. (Show the initial equilibrium in black or blue (pencil or pen). Show the change with an arrow or with a contrasting color. YOU MUST LABEL YOUR AXES AND LABEL THE CURVES.

5. Increased capital requirements imposed on U.S. banks, making them less able to lend.

6. An increase in foreign interest rates.

7. Reduced political instability in third world countries, which makes investors in the U.S. and Europe more interested in investing in these countires.

Answer 1

(i) Effect of increased capital requirements has been shown below (figure 1). Increased capital requirement is akin to increase in regulatory repo rate or capital reserve ratio.

(ii) An increase in foreign interest rate has the effect of money flowing out of the system. Money would be needed to be pumped into the economy to maintain the same equilibrium rate. The correlation is not direct and hence the phenomenon in itself may or may not have an impact on the equilibrium rates.

(iii) Increased instability generally reduces the appetite for taking in investments. Increased instability also increases the interest rate in the foreign country loan market. If there is enough risk appetite for the investors to invest in these foreign countries, the effect essentially becomes the same as mentioned in part (ii) of this question.

Nevertheless, the money generally flows back into the domestic currency market in terms of investors of foreign country wanting to have a safe haven for their investments. The effect on domestic interest rates, hence, is minimal.