Impact of Low Interest Rates on Businesses

Topics: Inflation, Monetary policy, Central bank Pages: 18 (6450 words) Published: October 21, 2010
Table of Contents
Executive Summary2

1.0 Introduction4

2.0 The Impact of Low Interest Rates on Asset Prices5

2.1 Impact on Businesses5

3.0 Exchange Rates and Low Interest Rates7

4.0 Low Interest Rates and Increase in Business Confidence9

5.0 The Effect on Spending and Saving Decisions of Businesses14

6.0 Impact of Low Interest Rates on Bond Prices16

7.0 Impact on Debt Repayment on Businesses19

8.0 Impact of Low Interest Rates on the Stock Market20

9.0 Conclusion21

List of References22

Executive Summary
Based on a framework, utilising recursive, and structural specifications, this study analyses the effects of interest rate, money growth and the movements in nominal exchange rate on real GDP growth and inflation in Sri Lanka for the period from 2008 to 2010. The results are broadly in line with the established empirical findings, especially when the interest rate is considered the monetary policy variable. Following a positive innovation in interest rate, GDP growth and inflation decrease while the exchange rate appreciates. When money growth and exchange rate are used as policy indicators, the impact on GDP growth contrasts with established findings. However, as expected, an exchange rate appreciation has an immediate impact on the reduction of inflation. Interest rate innovations are persistent, supporting the view that the monetary authority adjusts interest rates gradually, while innovations in money growth and exchange rate appreciation are not persistent. Several puzzling results emerge from the study: for most sub-samples, inflation does not decline following a contractionary policy shock; innovations to money growth raises the interest rate; when inflation does respond, it reacts to monetary innovations faster than GDP growth does; and exchange rate appreciations almost always lead to an increase in GDP growth. The purpose of this paper is to examine the effects of low interest rates currently maintained by the Central Bank of Sri Lanka on the Sri Lankan economy and specifically on the Sri Lankan private corporations. The paper starts with the explanation of what interest rates, monetary policy and the Central Bank in Sri Lanka. The main effects identified in the study include the effect on spending and saving decisions within corporations due to low interest rates. The effect on the cash flow of corporations and the effect on asset prices throughout the country. How the changing exchange rates affect Sri Lankan businesses including exporters and importers. The effect on bond prices within the country because of low interest rates and how businesses may choose to invest in bonds as result of rising bond prices due to low interest rates. The effects of the increase in business confidence due to low interest rates are discussed in detail within the report and finally how low interest rates affect on the businesses ability to repay its debts.

1.0 Introduction
An interest rate is the price a borrower pays for the use of money to borrow from a lender, for instance (Woodford 2003), a company might borrow capital from a bank to buy new assets for their business, and the return a lender receives for deferring the use of funds, by lending it to the borrower. Interest rates are fundamental tool for monetary policy in a capitalist economy. Interest rates are expressed as a percentage rate over the period of one year. The rate of interest targets are also a vital tool of monetary policy and are taken into account when dealing with variables like investment, inflation, and unemployment. The Central Bank of Sri Lanka is responsible for setting the rate of interest in the country. One of the core objectives of the Central Bank is economic and price stability. The Central Bank formulates and implements its monetary policy, i.e. actions to influence cost and availability of money, to attain this objective. The Monetary Law Act, the legislation under which the Central...
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