FM for Actuaries

302 CHAPTER 9
Unlike fiscal policy, monetary policy usually has broader effects on the economy.
As monetary policy is not directly targeting certain sectors of the economy, its
impacts are usually spread across the economy. Nonetheless, sectors that are more
interest-rate sensitive may have to adjust to monetary policy more aggressively. Finally,
as monetary policy usually does not require congressional or parliamentary
approval, it can be implemented relatively quickly.
9.5 Rate of Interest in an Open Economy
We have so far discussed interest rate changes in a single economy. As a country
trades in the international markets, the prices of its goods and services are influenced
by global demand and supply. Likewise, the interest rate of a country is
influenced by the global demand and supply of capital. This is particularly true if
a country has a policy of free capital mobility, by which it does not restrict the free
flow of capital.
During the global financial crisis of 2008, which originated from the U.S. economy,
the Fed implemented quantitative easying. It injected a large amount of liquidity
into the U.S. economy, driving the rate of interest to unprecedentedly low
level. The effects of quantitative easying, however, does not stay only in the U.S.
economy. Much of the liquidity leaks out of the U.S., partly to chase higher returns
elsewhere. This caused the rate of interest to be globally depressed.
In sum, in a globally open economy, interest rates are not just influenced by its
own conditions and government policies. It is also dependent on how inter-related
it is with respect to other countries, as well as what policies other countries are
implementing.
9.6 Summary
1. The rate of interest of a risk-free asset is a benchmark for the rate of interest
of other securities.
2. The nominal risk-free rate of interest is the sum of the real risk-free rate of
interest and the expected rate of inflation.
3. For a security in general, its rate of interest consists of premiums due to
liquidity, default risk and maturity risk.
4. Two important tools for the Fed to manage the supply of money are the reserve
ratio and interest rate charged at the Discount Window.