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Introduction
Interest rates are a key tool in the monetary policy of national government. The main impact of interest rates on agriculture is in terms of costs. This module will explain how interest rates are determined, the different types of interest rates, what causes interest rates to differ between countries and how they impact on agricultural markets.
This module will draw on concepts explained in Understanding Demand Factors for Agricultural Products, Understanding Supply Factors for Agricultural Products and How Demand and Supply Determine Price. As well, reference will be made to other modules that apply to the information in this module.
Interest Rates
Interest is the amount paid by a borrower to lend in exchange for the use of the lender's money for a certain period of time.
Interest is paid on loans or on debt securities, such as bonds, either at regular intervals or as part of a lump sum payment when the loan matures. In the case of operating loans from the bank, interest is paid in instalments based on an annual rate of interest for the life of the loan. In the case of bonds however, the buyer pays less than face value for the bond and receives a lump sum payment at maturity which is equal to the amount paid less the full value of the bond. For example, a buyer pays $90,000 for a bond with a one year maturity date. At the end of the year, he receives $100,000. The interest or return is $10,000 which is an annual return of 10 percent.
Interest rate trends in the economy either directly or indirectly affect spending, borrowing and investment decisions. The direct impacts are through the increased cost of investment and borrowing money. The indirect impact is through the influence of interest rates on exchange rates (see How Exchange Rates Affect Agricultural Markets). These decisions in turn affect the level of economic activity such as output, jobs and the level of inflation.
Interest Rate Determination
Interest rates are determined by the demand and supply of money within an economy. The supply of money is determined by the Bank of Canada, while the demand is based on the market demand of an economy for goods and services (see Understanding Demand Factors for Agricultural Products). The demand and supply of money can be influenced through the use of monetary and fiscal policy. Each type of policy affects the economy in different ways.
Monetary policy directly alters the supply of money in the economy. This has an almost immediate impact on interest rates.
The Bank of Canada, the central bank of Canada, uses its powers to influence the credit conditions that exist within the economy. The two main tools the Bank of Canada uses to influence the money supply are "cash" reserves and treasury bills. The Bank of Canada influences short-term interest rates which in turn influences the direction of the long-term rates.
Figure 1. How Demand and Supply of Money Determine Interest Rates
The Bank of Canada uses the drawdown-redeposit mechanism to change the level of "cash" reserves and hence the supply of money the chartered banks have available for a loan. By law chartered banks in Canada must maintain a reserve with the Bank of Canada called a "cash" reserve. The reserve is based on the level of deposits of various sorts held by the banks. As well, the Government of Canada maintains deposits with the Bank of Canada and the chartered banks.
The Bank of Canada may shift the government's money between the chartered banks and itself. This alters the short-term supply of money which influences short-term interest rates. A redeposit is a shift of money from the Bank of Canada to the chartered banks, while a drawdown is movement in the opposite direction.
A second tool used by the Bank of Canada to influence the direction of interest rates are open market operations. The bank may sell or buy treasury bills which will influence the supply-demand situation for a particular short-term security. Open market sales of treasury bills will increase the supply. If demand does not change, this will lower the price of treasury bills, thereby raising the interest yield. The actual sale or purchase of treasury bills by the Bank of Canada will not influence the short-term interest rate by much, but the move will signal to investors the intentions of the bank.
The weekly sale of Government of Canada treasury bills also allows the Bank of Canada the opportunity to influence interest rates through the open market. The weekly auction allows the Bank to bid higher than other participants and therefore keep the average yield lower than it otherwise would be. However, the bank's ability to influence the yield on the treasury bills is limited to a few basis points. Basis points are a measure of a change in the yield of a security. One basis point equals 1/100 of one percent.
The control of the supply of money by the central bank of a country is part of monetary policy and has a direct impact on interest rates. In the case of fiscal policy, the government uses changes in government spending and taxes to indirectly influence interest rates. In expansionary fiscal policy, taxes are cut or government spending is increased which causes an increase in the income of those in the economy. When income increases, the demand for money increases. If the supply of money stays the same while demand increases, interest rates would increase in order to equalize demand and supply. Interest rates will increase until a new balance in supply and demand is reached (see How Demand and Supply Determine Price). Under restrictive fiscal policy, spending is cut or taxes increased which decreases the income in the economy, lowering the demand for money and leading to lower interest rates. Fiscal policy has an indirect influence on interest rates and can take a long time to work its way through the economy.
Different Types of Interest Rates
Four types of interest rates commonly referred to are: 1) the bank rate, 2) the prime rate, 3) the market rate, and 4) the real rate of interest.
The Bank of Canada rate of interest, or bank rate, is the rate at which the Bank of Canada lends money to banks or make advances to chartered banks. The Bank of Canada uses a floating bank rate that is set every Tuesday. The rate is automatically set at one quarter of one percent (0.25 percent) above the rate of interest on the 91 day or three month treasury bills. At the weekly treasury bill auction run by the Bank of Canada for the Government of Canada, lenders submit sealed bids specifying how much they are prepared to lend the government at different rates of return. The government sells the amount of treasury bills it has offered at the auction to the bidders who offer the highest prices, which have the lowest rates of return.
The bank rate is the rate at which the Bank of Canada lends money to the chartered banks if they find themselves short of "cash" reserves. These loans have very strict conditions, including that they are only for one day. For the most part, the bank rate has little actual bearing on interest rates charged by the chartered banks. However, the rate is an indicator of the interest rate policy of the Bank of Canada.
The prime rate is a benchmark rate of interest established by commercial banks and is the rate charged for large loans made to their most credit worthy business and industrial customers. The prime rate is generally the lowest rate of interest charged by a bank, with other loans calculated as basis points above prime. The level of the prime rate is based on a number of factors including: 1) the bank's supply of money, 2) loan administration costs, 3) how much the bank has to pay for its supply of money and 4) competition from other banks. As was mentioned earlier, the Bank of Canada can influence interest rates by influencing the bank's supply of money through manipulation of "cash" reserves.
The market rate of interest is the rate charged by the bank to customers other than those that access the prime rate. Most market rates are above the prime rate and are based on several factors including: 1) perceived risks, 2) the nature of collateral offered, 3) the length of the loan, 4) the size of the loan, 5) competition in the loan market, and 6) the bank's relationship with the customer. Due to the number of variables involved in determining the market rates, a rate can be very specific to a loan.
The bank rate, the prime rate and the market rates are nominal rates of interest. When discussing the actual cost of borrowing money, reference is often made to the real rate of interest. The real rate of interest is an interest rate adjusted for inflation. Theoretically, what determines the real rate of interest is the productivity of capital. That is, the real rate of interest within a country is based on the return from investments in physical capital goods, such as a herd of cattle. The real interest rate is expected to change very little over time, not differ much between countries and is important in determining differences in the cost of borrowing money at different times and places. For a period of time in the 1970's, real interest rates in Canada were negative as inflation was higher than the nominal interest rate. By contrast, in 1992 the prime rate was much lower than in the 1970's, so the real rate of interest is higher due to the low rate of inflation.
Financial Markets and Capital Flows
The function of a financial market is to facilitate the flow of funds from savers to investors. The allocation of these savings occurs primarily on the basis of price which is expressed by interest rates. Investors that need funds must outbid others for the use of those funds. Interest rates are the primary mechanisms for bringing supply and demand into balance for a particular financial instrument across financial markets. If all investors and savers act in a rational manner, investors bidding the highest prices are the ones with the most promising investment opportunities. Savings are therefore allocated to these uses.
Figure 2. The Bank Rate, Prime Rate and Real Rate of Interest
The asset market trades in two types of wealth: (1) real money such as cash, and (2) interest bearing assets which are marketable claims on future income such as stocks and bonds. The cost of holding money or real money balances is the interest foregone by holding "cash" rather than other assets. The higher the rate of interest, the fewer cash people will hold.
When governments borrow, they must compete with other governments and investment opportunities for money. When they compete with private investment opportunities, they crowd out investment by pushing interest rates higher to attract capital.
Differences in interest rates between countries can have a very big impact on the amount of foreign investment that takes place in each country. In general, cross country interest rate relationships are likely to depend on how closely the financial markets of the countries are integrated, on exchange rate expectations and on whether financial assets in different currencies are regarded as close substitutes by borrowers and lenders after allowing for the impact on returns of expected exchange rate changes.
Interest rate arbitrage is the movement of funds from one money market center, such as Toronto, to another, such as New York, through the foreign exchange market, to obtain higher interest rates. The more closely integrated or associated the money markets, the faster the funds may move. The financial markets of Canada and the United States are very well integrated. This means that very small differences in rates of return within the two countries will result in large movements of capital. The financial markets of Europe, Japan and North America are becoming increasingly integrated. As a result, capital flows are susceptible to large swings based on small interest rate differentials. The movements in an interest rate can have a strong impact on the exchange rate of a country. (See How Exchange Rates Affect Agricultural Markets).
The impact of these large movements of funds was witnessed in the fall of 1992. As a result of domestic monetary policy to control inflation, interest rates in unified Germany were considerably higher than in the rest of the industrialized countries. This differential grew larger until such time as large volumes of funds moved to the Germany economy and interest rates and currencies around the world were affected. The result was that a German domestic policy had repercussions through the international money market on the Canadian bank and market rates of interest.
Effect on Agricultural Markets
Interest rates affect agricultural markets in two main ways. The first is the effect on costs which affect prices and the second is on investment which affects the level of production.
Costs
When marketing grain, it is important to understand and follow basis levels (see Basis - How Cash Grain Prices are Established). Within basis levels interest on grain held is an important cost component. Small movements in interest rates can increase or decrease the basis level and hence the price received on cash grain by several dollars per tonne.
Inventory is also a capital investment. The cost of holding inventory increases as interest rates rise. The cost of holding inventory is the interest that would have been collected had the commodity been sold. Stored product is inventory and the impact of interest rates on the cost of holding that inventory must be considered (see Grain Storage as a Marketing Strategy).
Storage costs are an important consideration in determining when to sell grain. Interest rates not only affect the storage costs of grain companies, but producers as well. When deciding if and for how long grain should be stored on farm, interest rates must be considered. (See Grain Storage as a Marketing Strategy). Price increases on stored grain must be enough to make up for the interest foregone if the crop had been sold at harvest rather than stored.
Interest costs must be included in the calculation of any cost of production analysis. When determining the breakeven for feeder cattle, the interest cost of the purchase price of the calves must be included in the analysis. Even if the calves come from within the operation, the interest foregone from the sale of the calves must be included in the cost calculation. (See Breakeven Analysis for Feeder Cattle).
Investment
Investment is spending on capital stock such as a breeding herd or a tractor. When interest rates are high profits from capital stock are lower after interest is paid than when rates are lower. This results in less investment. While high nominal interest rates can deter investment, it is the real rate of interest that has the greatest impact. The higher the interest rates, the less investment that takes place. In agriculture, high interest rates may slow the rate of investment in producing assets which could relay such things as the building of herds.
Summary
Interest rates are determined by the supply and demand for money within an economy. Governments may influence the interest rates through changes in spending and taxes. The central bank can influence rates by changing the money supply. International capital flows are influenced by even small differences in interest rates between countries, and can move rapidly. Large shifts in capital flows result in changes in demand for currencies which impact on exchange rates. Interest rates affect agriculture through costs and by influencing investment decisions.
Agricultural Marketing Manual - February, 1999
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