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The financial markets and the real economy are interrelated. Price formation in the financial markets is affected by expectations of future economic growth and inflation. On the other hand, changes in interest and exchange rates influence the consumption and investment decisions of corporations and households, and thereby future growth and inflation. A key issue is which factors affect the formation of interest and exchange rates, and how and to what extent this influences the real economy.
Since Denmark's monetary-policy objective is to hold the krone stable vis-à-vis the euro, Danmarks Nationalbank does not base its interest-rate decisions on macroeconomic developments. Danmarks Nationalbank normally changes its interest rates when the European Central Bank, ECB, changes the monetary-policy interest rates in the euro area.
The monetary-policy interest rates and expectations of their future course are of greatest significance to the short-term market rates, i.e. interest rates in the money-market and on bonds with maturities of up to 1-2 years. The relationship between the long-term interest rates and the monetary-policy interest rates is less straightforward.
Since the euro fluctuates against other currencies such as the US dollar and the Swedish krona, the Danish krones rate vis-à-vis these currencies will also fluctuate.
Fluctuations in Danish interest and exchange rates affect economic activity and prices in Denmark. Despite the increasing importance of adjustable-rate loans in recent years, long-term interest rates are particularly important to investments by corporations and to house purchases by households. At the same time, changes in the long-term interest rates will affect house prices, and thereby the wealth of households. This in turn affects private consumption. Changes in the krone rate vis-à-vis currencies other than the euro influence foreign trade via trading relations with countries outside the euro area.
3.1.1 External influences on Danish interest rates
When the foreign-exchange market is stable, the monetary-policy interest rates in Denmark normally follow the monetary-policy interest rates in the euro area, cf. Chart 3.1. If the krone rate against the euro tends to strengthen or weaken, Danmarks Nationalbank will first intervene in the foreign-exchange market to stabilise the krone. If the trend is persistent, Danmarks Nationalbank will unilaterally change the spread between the monetary-policy interest rates in Denmark and the euro area, cf. Chapter 1.
The short-term market interest rates are strongly influenced by the monetary-policy interest rates. This not only applies to the current level of the monetary-policy interest rates, but also to the expectations of the future course of them. In view of the fixed-exchange-rate policy vis-à-vis the euro the expectations of the future monetary policy in the euro area particularly affect the money-market interest rates in Denmark. The ECB sets the monetary-policy interest rates for the euro area in order to maintain price stability in the euro area, cf. Chapter 4.
The most obvious transmission from the monetary-policy interest rates to the market interest rates is seen in the money market and in bonds with maturities of up to 1-2 years, cf. Chart 3.2. In situations with foreign-exchange unrest that is perceived as temporary by financial markets, Danmarks Nationalbank's lending rate and the short-term money-market interest rates may, however, fluctuate considerably without significantly affecting the 1-2-year interest rates. This was the case e.g. during the foreign-exchange unrest in 1992-93. The correlation between long-term interest rates and the monetary-policy interest rates is more complex, since expectations of the future course of inflation and real interest rates in the euro area and in Denmark play a significant role.
3.1.2 The banks' interest rates
In situations with foreign-exchange unrest, which is perceived as temporary, Danmarks Nationalbank may raise the lending rate without simultaneously raising the discount rate. In such cases, the banks will often refrain from changing their retail interest rates, but change the rates of interest for agreements on money-market terms.
The close relation between the banks' retail interest rates on the one hand and Danmarks Nationalbank's interest rates and the short-term market rates on the other can be attributed to two main factors. Firstly, deposits with and lending by the banks are mostly subject to variable interest rates. Secondly, Danmarks Nationalbank's monetary-policy instruments and the short-term money market are a possible marginal source of financing for the individual bank.
3.1.3 Money-market interest rates and short-term bond yields
For slightly longer maturities, the money-market interest rates may in some periods deviate from Danmarks Nationalbank's interest rates, e.g. if the market expects Danmarks Nationalbank to change the monetary-policy interest rates within the next few months. Since Danmarks Nationalbank's interest rates normally follow the ECB's interest rates, the money-market interest rates in Denmark will follow developments in equivalent interest rates in the euro area very closely. Expectations of the ECB's monetary policy thus play a key role in determining the course of the slightly more longer-term Danish money-market interest rates.
Changes in Danmarks Nationalbank's interest rates that are perceived as temporary do not normally have any significant impact on interest rates for maturities of around 1-2 years.
3.1.4 Long-term interest rates
For many countries, the level of inflation is the dominant factor determining the level of long-term interest rates. If the financial markets are confident that monetary policy and other economic policies can keep inflation at a stable, low level, the long-term inflation expectations will be relatively stable, and changes in monetary-policy interest rates by the central banks will not necessarily have an impact on developments in long-term interest rates. On the other hand, if there is uncertainty concerning the ability and commitment to pursue an economic policy consistent with low inflation, bond investors will require a premium, and thereby higher interest rates as compensation for the risk of deterioration in the purchasing power of savings.
The long-term Danish bond interest rates are significantly influenced by the development in equivalent interest rates in the euro area. In a more global perspective the interest rates in the industrialised countries tend to show the same overall fluctuations, despite large exchange-rate fluctuations. This can be attributed to unrestricted international capital flows and relatively homogenous developments in inflation, cf. Chart 3.4.
Interest rates in different countries may naturally take different courses in line with different economic developments. This was the case in Denmark during the crisis in the European Monetary System in 1992-93 when the Danish-German 10-year yield differential widened for a short period, cf. Chart 3.5. The Chart also clearly shows how the transition to a consistent fixed-exchange-rate policy in 1982 gradually gained credibility, whereby devaluation and inflation expectations in Denmark were reduced. As a consequence, the yield differential to Germany narrowed considerably from more than 12 per cent in 1982 to around 0.25 per cent in 2002.
3.1.5 The effective krone rate
The krone may weaken against one currency and strengthen against another at the same time. To assess when the krone overall weakens or strengthens the "effective krone rate" is calculated. It is a weighted average of the bilateral exchange rates vis-à-vis Denmark's major trading partners, cf. Chart 3.6. An increase in the effective krone-rate index indicates a strengthening of the krone vis-à-vis the weighted average of the currencies in the index.
The effective krone-rate index has been relatively stable since 1980, even though the exchange-rate policy is not aimed at managing the index. On the other hand, the bilateral krone rate has varied considerably vis-à-vis individual currencies, with the weakening of the Swedish krona and the strengthening of the yen as the most extreme examples among the currencies in Chart 3.6.
The weights in the krone-rate index reflect the competition environment for trade in industrial goods and are shown in Table 3.1. The euro area is clearly Denmark's most important trading partner, accounting for almost 60 per cent of the weight basis. However, in view of the fixed-exchange-rate policy, fluctuations in the effective krone rate are attributable to the krone's fluctuation against the largest trading partners outside the euro area.
The impact of interest and exchange rates on private consumption and real capital investments depends inter alia on the development in the wealth of corporations and households, and the structure of their assets and liabilities.
Households' purchases of real property and large consumer goods items are financed predominantly via mortgage-credit loans. Mortgage-credit loans often have maturities of 20 or 30 years, and for most of these loans the interest rate is fixed throughout the period. Mortgage-credit loans are, however, usually callable, so that they can be converted to loans at lower interest rates should this prove favourable in connection with falling interest rates. This right is widely used.
In recent years, adjustable-rate loans as a proportion of total lending by the mortgage-credit institutes has increased. The rate of interest for these loans is adjusted to the current market terms with an agreed frequency, e.g. annually, although the frequency can be up to 5 years. At end-2002 adjustable-rate loans accounted for around 30 per cent of total lending by the mortgage-credit institutes, against 6 per cent at the end of 1999. Together with borrowing from the banks this implies that almost half of the interest payments made by households are affected by the development in the short-term interest rates.
For the overall household sector, real property is by far the largest wealth asset. The households also hold certain financial assets such as bank deposits and bonds. For most households, net interest expenditure tends to increase when interest rates rise.
In general terms fluctuations in house prices and in long-term interest rates are related. If long-term interest rates are rising, it becomes more expensive to finance a home purchase, so that house prices will tend to fall. However, Chart 3.7 shows that there is not always a strong co-variation between quarter-on-quarter fluctuations in house prices and in the 10-year bond yield.
For households whose homes are financed with fixed-rate loans, an increase in long-term interest rates will reduce the market value of the debt. Since for most households the property value exceeds the housing debt, the deterioration in property value as a consequence of rising interest rates will often exceed the reduction of the debt. This erodes the net housing wealth. For households with adjustable-rate loans an increase in interest rates will reduce the market value of the debt by far less than would have been the case with a fixed-rate loan. Interest-rate fluctuations will thus have a stronger impact on net housing wealth.
Interest-rate fluctuations also affect stock prices. Theoretically, the price of a share is often described as the discounted value of expected future dividend payments. The higher the interest rate, the lower the present value of a given future dividend payment. Therefore, stock prices and long-term interest rates will take opposite courses, all other things being equal. However, there is no pronounced relationship in practice, cf. Chart 3.8, which shows the correlation between day-to-day percentage changes in stock prices measured by the KFX index and fluctuations in the 10-year Danish government bond yield. The correlation has been predominantly negative since 1990, but positive for a prolonged period in recent years. This can be attributed to the impact on stock prices of factors other than interest rates.
Empirical analyses indicate that stock-price fluctuations in Denmark have a relatively limited impact on private consumption. A large proportion of Danish households have only little or no wealth invested in stocks. However, there is more share ownership via mutual funds, and when stock portfolios via pension schemes are included, the wealth of many households will directly or indirectly be influenced by stock-price fluctuations. However, experience shows that fluctuations in stock prices have only a minor impact on the households' consumption behaviour.
Table 3.3 shows that bank loans account for a considerably larger share of corporations' borrowing from banks and mortgage-credit institutes than is the case for households. One underlying factor could be that the value of the corporate sectors buildings limits their borrowing from mortgage-credit institutes. Furthermore, the interest-rate margin between mortgage-credit loans and bank loans is narrower for corporations than for households.
It is difficult to determine the sensitivity of corporations to fluctuations in interest rates for loans with different maturities solely on the basis of the structure of their borrowing, as the corporation may adjust the sensitivity via various financial instruments. For example, a corporation may convert a fixed-rate loan to a floating-rate loan via an interest-rate swap, cf. Chapter 2.
Corporations may use other sources of financing than bank and mortgage-credit loans, such as the issue of shares. A rising stock price will, all other things being equal, make it more attractive for the corporation to issue shares to finance investments in new real capital.
Changes in interest and exchange rates influence the future course of prices, output and employment. Higher interest rates and/or a strengthening of the effective krone rate will, all other things being equal, tend to dampen economic activity and inflation, while lower interest rates and/or a weakening of the effective krone rate will have the opposite effect.
The theoretical and empirical literature on the effect of changing interest and exchange rates on the economy often distinguishes between a number of different channels via which changes in interest and exchange rates affect economic activity, cf. Box 3.1. The channels are described in the following by means of general, empirical relations from the development in interest rates and exchange rates to key real-economic quantities such as investment, consumption and foreign trade.
3.3.1 Real-capital investments
Housing investments are also influenced by interest rates via the effect on the costs of new construction compared to purchasing existing real property. A drop in interest rates often leads to higher cash prices, cf. Chart 3.7. An increase in the cash price for real property makes new construction relatively cheaper than purchasing an existing property. This stimulates housing investments, cf. Chart 3.10.
3.3.2 Private consumption
However, empirical studies indicate that consumption patterns are mainly influenced by other factors than interest rates. Changes in the private sector's wealth, primarily housing wealth, is by far the single most significant explanation for the variation in consumption as a ratio of disposable income, as wealth owners translate a proportion of a change in wealth into private consumption. However, the relation has been less pronounced since the reduction of the tax deductibility of interest payments introduced with the Whitsun Package of Economic Measures in 1998. After 1998, housing prices have increased considerably, while private consumption has been more subdued, cf. Chart 3.11.
A decline in the effective krone rate will, all else being equal, make Danish goods cheaper abroad, as the price in foreign currency becomes lower. The price in Danish kroner of goods manufactured abroad will increase. In so far as the direct effect on prices is not offset by changes in producer prices in Denmark and abroad, the volume of exports will tend to increase, while the volume of imports will decrease. This will stimulate economic activity and will induce upward pressure on domestic prices, both directly via higher import prices, and indirectly via expanded activity.
It is difficult to establish a close empirical relation between the course of the effective krone rate and that of imports and exports. The principal reason is that the volume of foreign trade normally reacts sluggishly to relative price changes between goods manufactured in Denmark and abroad, while the development in the size of the market, including cyclical trends, plays a key role. Moreover, in the short term, the relative price development has only a minor impact on determining the market shares of imports and exports. A further complication is that exporters and importers also change their prices when the exchange rate changes, which offsets the direct price effect of the exchange-rate change. For example, experience shows that Danish exporters typically raise the price (in Danish kroner) to match the world-market price when the krone weakens. Similarly, foreign exporters often lower the price in their own currency when the krone weakens. Exporters and importers may at the same time conclude forward foreign-exchange contracts in order to cushion some of the effects of future exchange-rate fluctuations.
Chart 3.12 shows the development in the market share for Danish exports of manufactured goods together with the relative Danish export price. If Danish export prices rise, whereby Danish goods become more expensive abroad, the market share is assumed to decline. In some periods this relation is less obvious, as other factors carry more weight than the development in relative export prices, cf. Nielsen (1999).
Chart 3.13 shows the import market share in Denmark and the relative import price. As before, a negative relation between the import price and the market share in Denmark should be expected.
The following seeks to quantify how interest and exchange-rate changes influence economic growth and inflation using Danmarks Nationalbank's macroeconomic model (Mona).
Section 3.4.1 first illustrates the real-economic effects of an isolated decline in Danish interest rates and an isolated weakening of the effective krone rate.
An experiment based on changes only in Danish interest or exchange rates may appear very theoretical in the light of Denmark's fixed-exchange-rate policy. However, the calculations illustrate the extent of the real-economic effects of "shocks" to interest and exchange rates respectively. As a supplement, section 3.4.2 describes calculations of the effects of an increase in the euro area's monetary-policy interest rates followed by a corresponding raising of the monetary-policy interest rates in Denmark.
3.4.1 The effects of isolated changes in Danish interest and exchange rates
A decline in interest rates and a weakening of the effective krone rate both have a positive impact on economic activity. For both experiments, Chart 3.14 shows the impact on GDP over time compared to a given base scenario.
An expansionary GDP effect is seen on a drop in interest rates by 1 per cent. The effect peaks after 4-6 years, when GDP is approximately 1 per cent higher than in the base scenario. After this time, the effect gradually subsides. The experiment where the krone rate weakens shows a more moderate total impact on GDP.
The effects on activity in the interest-rate experiment can be attributed primarily to private consumption via the housing market, while the activity effects in the exchange-rate experiment can be attributed mainly to exports via improved competitiveness.
The effect on consumer prices is far more pronounced in the exchange-rate experiment than in the interest-rate experiment, cf. Chart 3.15. A weakening of the krone rate immediately affects consumer prices via import prices, which is the principal reason for the somewhat more pronounced price effect. In addition, wage costs rise as a result of increasing activity and employment, whereby prices go up. The price effects of a decrease in interest rates can be attributed primarily to higher wage costs, causing prices to rise.
3.4.2 The effects of a temporary increase in interest rates in the euro area and Denmark
The raising of the monetary-policy interest rates in the euro area is not expected by the market in advance. However, the market is assumed to correctly expect the monetary-policy interest rates to return to the original level after 2 years. This brings an immediate increase in the 10-year bond yield by around 0.20 percentage points. The krone follows the euro, and the two currencies are assumed to appreciate by 2 per cent vis-à-vis all other currencies. This effective krone rate thus appreciates by 0.85 per cent, cf. also the weights in the effective krone rate in Table 3.1. Both long-term interest rates and the effective krone rate are back at the original level after the two years.
The experiment also e.g. considers that the interest-rate increase and the euro's appreciation dampen growth in the euro area, resulting in lower growth in Danish exports to the euro area.
Table 3.4 summarises the calculations. The higher long-term interest rates lead to falling house prices, which has a negative impact on private consumption. Exports are reduced as a result of the appreciation of the effective krone rate and reduced demand in the euro area. The overall impact on GDP for the first five years is negative compared to the base scenario.
The krone's appreciation leads to falling consumer prices immediately after the interest-rate increase. Furthermore, the reduced economic activity contributes to falling wage levels, which in turn contributes to falling consumer prices in subsequent years compared to the base scenario.
For a horizon beyond 5 years the lower wage increases will gradually contribute to a renewed upswing in activity, after which GDP and consumer prices gradually return to the base scenario.
Comparison with similar surveys for the euro area member states shows that the Danish economy is generally less sensitive to fluctuations in short-term interest rates than most other economies. This can be attributed to the relatively widespread use of financing at fixed interest rates in Denmark.
Andersen, Jens Verner, Hanne Lyngesen and Erik Haller Pedersen (1999), Credit Expansion During Two Booms, Danmarks Nationalbank, Monetary Review, 2nd Quarter.
Angeloni, Ignazio, Anil Kashyap, Benoît Mojon and Daniele Terlizzese (2002), Monetary Transmission in the Euro Area: Where Do We Stand?, ECB Working Paper No. 114.
Christensen, Anders Møller and Kristian Kjeldsen (2002), Adjustable-Rate Mortgages, Danmarks Nationalbank, Monetary Review, 2nd Quarter.
Christensen, Anders Møller and Dan Knudsen (1992), MONA: a quarterly model of the Danish economy, Economic Modelling, Vol. 9, No. 1.
Danmarks Nationalbank (2003), A Quarterly Model of the Danish Economy, forthcoming.
Statistics Denmark (2003), Financial Accounts 1995-2001, Statistical Reports (in Danish). National Accounts and Balance of Payments, No. 2003:3, 31 January.
Devereux, Michael B., Charles Engel and Peter E. Storgaard (2002), Endogenous exchange rate pass-through when nominal prices are set in advance, Danmarks Nationalbank, Working Paper No. 7, forthcoming in Journal of International Economics.
ECB (2000), Monetary policy transmission in the euro area, Monthly Bulletin, July.
ECB (2002), Recent findings on monetary policy transmission in the euro area, Monthly Bulletin, October.
Ejerskov, Steen (2000), Stock Prices, Property Prices and Monetary Policy, Danmarks Nationalbank, Monetary Review, 4th Quarter.
Ellingsen, Tore and Ulf Söderström (2001), Monetary policy and market interest rates, American Economic Review, vol. 91, no. 5.
Hansen, Niels L. (1995), National and International Elements of the development in Interest Rates in 1993-95, Danmarks Nationalbank, Monetary Review, November.
Hansen, Niels Lynggård (1997), Monetary Conditions Indices, Danmarks Nationalbank, Monetary Review, May.
Knudsen, Dan (1993), Transmission to and from interest rates, Appendix 3 in: Erik Hoffmeyer, Monetary policy issues 1965-1990 (in Danish), Danish Monetary History, Volume 5, Danmarks Nationalbank.
Knudsen, Dan (2002), Measuring expected inflation and the real rate of interest, Nationaløkonomisk tidsskrift, No. 1.
Knudsen, Ulrik (2003), Conversions of 30-Year Mortgage-Credit Bonds during the Last 10 Years, Danmarks Nationalbank, Monetary Review, 2nd Quarter.
Kuttner, Kenneth and Patricia Mosser (2002), The Monetary Transmission Mechanism: Some Answers and Further Questions, in: Economic Policy Review, Federal Reserve Bank of New York, Vol. 8, No. 1, May.
Ludwig, Alexander and Torsten Sløk (2002), The impact of changes in stock prices and house prices on consumption in OECD countries, IMF Working Paper No. 02/1.
Nielsen, Heino Bohn (1999), Market Shares of Manufactured Exports and Competitiveness, Danmarks Nationalbank, Monetary Review, 2nd Quarter.
Pedersen, Erik Haller (1996), Real Effective Exchange Rates, Danmarks Nationalbank, Monetary Review, May.
Pedersen, Erik Haller (1998a), Revision of the Weights for Calculation of the Nationalbank's Effective Krone Rate Index, Danmarks Nationalbank, Monetary Review, 2nd Quarter.
Pedersen, Erik Haller (1998b), Capital Gains on Stocks and Owner-Occupied Homes, Danmarks Nationalbank, Monetary Review, 4th Quarter.
Pedersen, Erik Haller (2001), Development in and Measurement of the Real Interest Rate, Danmarks Nationalbank, Monetary Review, 3rd Quarter.
Saabye, Niki (2003), The Equity Risk Premium, Danmarks Nationalbank, Monetary Review, 1st Quarter.
van Els, Peter, Alberto Locarno, Julian Morgan and Jean-Pierre Villetelle (2001), Monetary policy transmission in the euro area: What do aggregate and national structural models tell us?, ECB Working Paper No. 94.
Ølgaard, Christian (1992), The Effective Krone Rate and Competitiveness, Danmarks Nationalbank, Monetary Review, February.
Ølgaard, Christian (1997), Short-Term Correlations between 10-year Government Bond Yields in Selected Countries, Danmarks Nationalbank, Monetary Review, May.
See e.g. Ellingsen and Söderström (2001) for an analysis of how long-term interest rates react differently in different situations when the monetary-policy interest rates are changed.
The relation between interest-rate developments in Denmark and abroad is described in e.g. Hansen (1995) and in Ølgaard (1997).
The weights are calculated on the basis of trade in industrial goods in 1995. The effective krone rate index is described in further detail in Ølgaard (1992) and Pedersen (1996 and 1998a).
A compilation of the total financial assets and liabilities of households and corporations for 2001 can be found in Statistics Denmark (2003). From the autumn of 2003 Danmarks Nationalbank intends to publish quarterly financial accounts showing total financial assets and liabilities for the main sectors of the Danish economy. Andersen, Lyngesen and Pedersen (1999) analyse credit extension by banks and mortgage-credit institutes to households and corporations since 1980 and the relation with the business cycle.
See e.g. Knudsen (2003) for a discussion of conversions of 30-year mortgage-credit bonds since the mid-1990s.
Net housing wealth is the cash value of the home less the cash value of its financing.
Christensen and Kjeldsen (2002) give a more detailed review of the relations between interest-rate fluctuations and housing wealth with various types of financing.
See Saabye (2003) for a description of the pricing of stocks. Pedersen (1998b) and Ejerskov (2000) discuss stock prices and house prices in more general terms, and their impact on prices, consumption, investments and monetary policy.
For example, the dampened economic growth in recent years may have eased inflationary pressure, giving lower interest rates, but it may also have reduced expectations of corporations' future earnings. If this effect is stronger than the discounting effect of the lower interest rates, the relation between stock prices and interest rates becomes positive.
 See e.g. Ludwig and Sløk (2002) for an analysis of the significance of trends in the stock and housing markets to private consumption in a number of OECD countries.
 More recent discussions of the issue and literature are found in e.g. Angeloni et al. (2002), ECB (2000 and 2002), Kuttner and Mosser (2002) and van Els et al. (2001).
 In theory, the real-interest rate is the relevant interest rate, rather than the nominal interest rate. Assuming rigid wage and price developments, at least in the short term, and considering the taxation system, results in a more complex problem, cf. Pedersen (2001) and Knudsen (2002).
 See e.g. Devereux, Engel and Storgaard (2002).
 Mona is described in Christensen and Knudsen (1992) and Danmarks Nationalbank (2003). Setting up monetary and financial condition indices is an alternative method to quantify the impact of interest and exchange-rate changes on the real economy, cf. Hansen (1997).
 This could result in a rule of thumb to the effect that over a period of some years an interest-rate decrease by 1 per cent causes GDP to rise by approximately 1 per cent. This conclusion is also reached in Knudsen (1993).
 This interest-rate change and its consequences for the euro area are described in van Els et al. (2001). These results are used as input to the calculations in Mona. The experiment with Mona is described in further detail in Danmarks Nationalbank (2003).
 Since the rate of interest is 1 percentage point higher in two years out of 10 compared to the base scenario.
 See e.g. van Els et al. (2001).
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