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speculation deregulation and the interest rate leonard a rapping and lawrence b pulley n.
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Speculation , Deregulation, and the Interest Rate LEONARD A. RAPPING AND LAWRENCE B. PULLEY PowerPoint Presentation
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Speculation , Deregulation, and the Interest Rate LEONARD A. RAPPING AND LAWRENCE B. PULLEY

Speculation , Deregulation, and the Interest Rate LEONARD A. RAPPING AND LAWRENCE B. PULLEY

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Speculation , Deregulation, and the Interest Rate LEONARD A. RAPPING AND LAWRENCE B. PULLEY

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  1. Speculation, Deregulation, and the Interest RateLEONARD A. RAPPING AND LAWRENCE B. PULLEY By Alex Macri

  2. The article is intended to identify the cause of the abnormally high interest rates which prevailed throughout the 1980’s. • In providing the historical context, R&P ascertain that during this decade the magnitude of the interest rates was the highest it had ever been since the beginning of the Industrial Revolution. • The thesis R&P attempt to refute is that these high interest rates resulted from the Fed’s indirect credit rationing via the reserve requirement channel.

  3. R&P state that since financial innovations during this period severed the link between reserve requirements and credit rationing, their counter-thesis pins the blame for these high interests rates on deregulation/financial innovation. • R&P construct their thesis thusly: • B/w 1969 and 1977, the Fed managed investor expectations by pegging interest rates; Treasury bonds fluctuated b/w 6 and 7%

  4. In other words everyone knew the “rules of the game” and financial speculation was confined within the boundaries established by these rules. • In 1978 the Fed ceased this interest pegging policy. • Investors interpreted this abandonment and the concomitant decontrol of deposit rates as a signal of a looming recession. • Consequently many investors became destabilizing bears.

  5. In order to bolster their thesis, R&P draw a demarcation line b/w financial instruments whose returns were subject to regulation and those whose were not. • They argue that in a period of volatility generated by “unfair” distribution of income, “irrational” speculation ensues in those financial instruments whose returns are unregulated: real estate, equities, collectibles, gold and foreign exchange • Controlling the interest rate is an effective method of controlling this speculation.

  6. In the context of deregulated interest rates, returns on interest bearing assets will begin to increase in some direct proportion with an expected increase in these assets’ returns. • This explanation of high interest rates is called the portfolio or asset preference explanation. • A different model for explaining interest rate levels establishes the demand for credit on the basis of prices and the scale of output while the supply of credit is determined by the savings rate and the amount of credit creation by the banking system.

  7. Inflation expectations are yet another interest rate setting model. The prospect of inflation will increase the demand for money (up to a certain point) via both the supply and demand channels. • Fisher model: R t = Em(rt |фt-1 ) + Em(πt|фt-1 )

  8. The first term can be eliminated with the assumption that in the long run the real rate will equilibrate around a more or less constant value denoted by ρ. • The small deviations from this constant value are denoted by µt. • Fisher equation than becomes R t = ρ + Em(πt|фt-1 ) + µt.

  9. This equation has not proved to be empirically robust; the expected real interest rate is not constant. • In order to address this inadequacy Carlson (1977) and Tanzi (1980) examined the impact of changes in real variables. • The augmented model than becomes: 1) R t = Em(rt |фt-1 ) + β1Em(πt|фt-1 ) + µt 2) Em(rt |фt-1 ) = ρ - β2 Em(πt|фt-1 )– β3 LIQt + β4ACTt + β5σRt+ υt

  10. Em(rt |фt-1 ) = captures incomplete adjustment to expected inflation level. ρ - β2 LIQ = proxy for shifts in LM curve. ACT = proxy for shifts in IS curve. σRt = interest rate volatility ρ = constant component of expected real interest rate. Combining 1) and 2)

  11. R t = ρ + β0Em(πt|фt-1 ) – β3 LIQt+β4ACTt + β5σRt+ wt where: β0 = β1 – β2 wt=µt + υt • The data plugged into the model: Expected inflation rates gathered from records of predictions made by economists.

  12. Six month T bills rates from 6:1959 to 12:1983 were used as proxies for nominal interest rates. • M1 growth is the proxy for liquidity • σRt = interest rate volatility. • R&P find that interest rates after 1979 continued to rise despite a decrease in actual and expected inflation.

  13. R&P conclude that the high interest rates characteristic of the period cannot be explained by the traditional interest rate models or foreign exchange markets. • R&P posit that irrational speculation coupled with interest rate deregulation have far more explanatory power for these rates. • The solution is to therefore penalize speculation. Doing this would indirectly control interest rates.

  14. In the absence of such penalization R&P forecast the persistence of high interest rates. • Although R&P are encouraged by the Fed’s determination to step in as required in order to prevent a repeat of the Great Depression, they believe the power to selectively penalize speculators must also be a part of the regulatory regime.