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Group 24 ‘s members
1. Phan Văn Khải MSSV: 1111110401
2. Nguyễn Tiến Dũng MSSV: 1111110447
3. Nguyễn Thanh Thư MSSV: 1111110590
4. Dương Ngọc Ánh MSSV: 1111110516
Table of ContentsABSTRACT..........................................................................................................................................2
INTRODUCTION.................................................................................................................................3
1. Context of the report................................................................................................................3
2. Objective of the report.............................................................................................................3
3. Structure of the report.............................................................................................................3
CHAPTER 1: BACKGROUND...........................................................................................................4
1. Interest rate...............................................................................................................................4
1.1. Definition and formula......................................................................................................4
1.2. Annual percentage rate (APR)..........................................................................................5
1.3. Interest rate targets............................................................................................................5
2. Inflation.....................................................................................................................................6
2.1. Definition............................................................................................................................7
2.2. Measurement of Inflation..................................................................................................7
2.3. The causes of inflation.......................................................................................................7
CHAPTER 2: IMPACT OF INTEREST RATE ON INFLATION IN VIETNAM.............................8
1. Impact of interest rate on household savings........................................................................9
2. Impact of interest rate on enterprise investment................................................................11
CONCLUSION...................................................................................................................................15
REFERENCE......................................................................................................................................16
1
ABSTRACT
Empirical knowledge shows that adjustments to the interest rates usually come right
after the inflation phenomena as an instrument to recover economic balances. The case holds
right in numerous countries, including Vietnam. Thus, there must be certain links between
interest rate and inflation.
This report aims to provide crucial knowledge about the way interest rates affect
inflation in Vietnam by analyzing behaviors of individuals (people who send money to the
banks) and enterprises (those who borrow money from the banks). In general, raising interest
rates tends to reduce the amount of money in circulation by increasing savings and
decreasing investments. Accordingly, as a respond to the decreased money growth, inflation
rate is inclined to go down.
2
INTRODUCTION
1. Context of the report
Theoretically, the Fisher hypothesis assumes that there is a co-integration link between
inflation and interest rate. That is to say, nominal interest rates move one-for-one with
expected inflation. As time gone by, this theory enjoyed numerous researches and remained
one of the cornerstones of monetary economics. Empirical knowledge also points out that
changes in the inflation rates are likely to be the respond to interest rates movements. For
example, the U.S. inflation of the 1970s and 80s can be fully accounted for by the
corresponding increase in money growth rates, and the return to relatively low inflation rates
in the 1990s can be explained by the correspondingly low average rate of money supply
growth in that decade. Considering these issues, what is the connection between interest
rates and inflation?
2. Objective of the report
This report is to basically explain the way interest rates influences inflation rates. In
order to achieve the target, we simplify the situation by dividing all economic entities into
two groups: individuals (or households) and enterprises. They are those who affect the
economy’s saving rates through the act of lending or borrowing money. By analyzing the
two kinds of entities’ reaction to interest rates adjustments, we find out how the money
growth is affected, leaving the inflation rates more stable. The process is important for the
government in terms of deciding whether to lower or increase the “cost of money “ so that
the whole economic system shall not be in crisis.
3. Structure of the report
The document is divided into 2 chapters:
Chapter 1 provides background knowledge of the terms discussed, which are interest
rates, . You may find their definitions, related terms and roles played in the economy clearly
and logically stated in the section. However, those who have specialized knowledge may
skip this chapter.
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Chapter 2 shows the impacts that rates of interest have on inflation. In order to keep things
simple, we illustrate the way households and enterprises react to changes in the interest rates
one-by-one. Based on those response, the link between the two terms is revealed.
CHAPTER 1: BACKGROUND
1. Interest rate
1.1. Definition and formula
a) Definition
The amount charged, expressed as a percentage of principal, by a lender to a borrower
for the use of assets. Interest rates are typically noted on an annual basis, known as
the annual percentage rate (APR). The assets borrowed could include, cash, consumer goods,
large assets, such as a vehicle or building. Interest is essentially a rental, or leasing charge to
the borrower, for the asset's use. In the case of a large asset, like a vehicle or building, the
interest rate is sometimes known as the "lease rate". When the borrower is a low-risk party,
they will usually be charged a low interest rate; if the borrower is considered high risk, the
interest rate that they are charged will be higher.
b) Interest rate formula
There are two types of interest rates: The nominal interest rate and the real interest rate:
- The nominal interest rate is the amount, in percentage terms, of interest payable. For
example, suppose a household deposits $100 with a bank for 1 year and they receive
interest of $10. At the end of the year their balance is $110. In this case, the nominal
interest rate is 10% per annum.
- The real interest rate, which measures the purchasing power of interest receipts, is
calculated by adjusting the nominal rate charged to take inflation into account.
(See real vs. nominal in economics.) If inflation in the economy has been 10% in the
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year, then the $110 in the account at the end of the year buys the same amount as the
$100 did a year ago. The real interest rate, in this case, is zero.
After the fact, the 'realized' real interest rate, which has actually occurred, is given by
the Fisher equation, and is
where p = the actual inflation rate over the year.
The expected real returns on an investment, before it is made, are:
= real interest rate
= nominal interest rate
= expected inflation over the year
1.2. Annual percentage rate (APR)
What is commonly referred to as the interest rate in the media is generally the rate
offered on overnight deposits by the Central Bank or other authority, annualized.
The total interest on a loan or investment depends on the timescale the interest is
calculated on. In retail finance, the annual percentage rate and effective annual rate concepts
have been introduced to help consumers easily compare different products with different
payment structures. In business and investment finance, the effective interest rate is often
derived from the yield, a composite measure which takes into account all payments of
interest and capital from the investment. The notion of annual effective discount rate, often
called simply the discount rate, is also used in finance, as an alternative measure to the
effective annual rate which is more useful or standard in some contexts. A positive annual
effective discount rate is always a lower number than the interest rate it represents.
1.3. Interest rate targets
a) Elasticity of substitution
5
The elasticity of substitution (full name should be the marginal rate of substitution of
the relative allocation) affects the real interest rate. The larger the magnitude of the elasticity
of substitution, the more the exchange, the lower the real interest rate.
b) Output and unemployment
Interest rates are the main determinant of investment on a macroeconomic scale. The
current thought is that if interest rates increase across the board, then investment decreases,
causing a fall in national income. However, higher rates leads to greater investment in order
to earn the interest to pay the depositors. Higher rates encourage more saving and thus more
investment and thus more jobs to increase production to increase profits. Higher rates also
discourage economically unproductive lending such as consumer credit and mortgage
lending. Also consumer credit tends to be used by consumers to buy imported products
whereas business loans tend to be domestic and lead to more domestic job creation (and/or
capital investment in machinery) in order to increase production to earn more profit.
A government institution, usually a Central bank, can lend money to financial
institutions to influence their interest rates as the main tool of monetary policy. Usually
central bank interest rates are lower than commercial interest rates since banks borrow
money from the central bank then lend the money at a higher rate to generate most of their
profit.
By altering interest rates, the government institution is able to affect the interest rates
faced by everyone who wants to borrow money for economic investment. Investment can
change rapidly in response to changes in interest rates and the total output.
c) Monetary and inflation
Loans, bonds, and shares have some of the characteristics of money and are included in
the broad money supply.
By setting the nominal interest rate, the government institution can affect the markets
to alter the total of loans, bonds and shares issued. Generally speaking, a higher real interest
rate reduces the broad money supply. Through the quantity theory of money, increases in the
money supply lead to inflation.
2. Inflation 6
2.1. Definition
In economics, inflation is a sustained increase in the general price level of goods and
services in an economy over a period of time. When the general price level rises, each unit
of currency buys fewer goods and services. Consequently, inflation reflects a reduction in
the purchasing power per unit of money – a loss of real value in the medium of exchange
and unit of account within the economy. A chief measure of price inflation is the inflation
rate, the annualized percentage change in a general price index (normally the consumer price
index) over time.
Inflation's effects on an economy are various and can be simultaneously positive and
negative. Negative effects of inflation include an increase in the opportunity cost of holding
money, uncertainty over future inflation which may discourage investment and savings, and
if inflation were rapid enough, shortages of goods as consumers begin hoarding out of
concern that prices will increase in the future. Positive effects include ensuring that central
banks can adjust real interest rates (to mitigate recessions and encouraging investment in
non-monetary capital projects).
2.2. Measurement of Inflation
There are some tools that used to measure inflation, however CPIs and PPIs are
commonly used:
Consumer price indices (CPIs) which measure the price of a selection of goods
purchased by a "typical consumer".
Producer price indices (PPIs) which measure the price received by a producer. This
differs from the CPI in that price subsidization, profits, and taxes may cause the
amount received by the producer to differ from what the consumer paid. There is also
typically a delay between an increase in the PPI and any resulting increase in the CPI.
Producer price inflation measures the pressure being put on producers by the costs of
their raw materials. This could be "passed on" as consumer inflation, or it could be
absorbed by profits, or offset by increasing productivity.
2.3. The causes of inflation
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Economists generally believe that high rates of inflation are caused by an excessive
growth of the money supply. However, money supply growth does not necessarily cause
inflation. Some economists maintain that under the conditions of a liquidity trap, large
monetary injections are like "pushing on a string”. Views on which factors determine low to
moderate rates of inflation are more varied. Low or moderate inflation may be attributed to
fluctuations in real demand for goods and services, or changes in available supplies such as
during scarcities, as well as to changes in the velocity of money supply measures. The
consensus view is that a long sustained period of inflation is caused by money supply
growing faster than the rate of economic growth.
However, in short and medium term, inflation may be affected by supply and demand
pressures in the economy, and influenced by the relative elasticity of wages, prices and
interest rates. The question of whether the short-term effects last long enough to be
important is the central topic of debate between monetarist and Keynesian schools. In
monetarism, prices and wages adjust quickly enough to make other factors merely marginal
behavior on a general trend line. In the Keynesian view, prices and wages adjust at different
rates, and these differences have enough effects on real output to be "long term" in the view
of people in an economy.
Today, most economists favor a low and steady rate of inflation. The task of keeping
the rate of inflation low and stable is usually given to monetary authorities. Generally, these
monetary authorities are the central banks that control monetary policy through the setting of
interest rates, through open market operations, and through the setting of banking reserve
requirements.
CHAPTER 2: IMPACT OF INTEREST RATE ON INFLATION IN VIETNAM
The impact of interest rates on inflation of more or less, fast or slow depending on the
socio-economic characteristics of each country, in each country, each stage of development
of financial markets, the level of impact of different interest rates.
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For Vietnam in 2000 - 2012, the impact of interest rate on inflation can be seen by
considering the impact of interest on the money market toward the behavior of individuals
and enterprises.
1. Impact of interest rate on household savings
Domestic saving, including household saving, plays an important role in economic
growth, especially for countries in the process of capital accumulation like Vietnam.
According to data from the World Bank, Gross domestic saving ( % of GDP) in Vietnam has
been continuously rising from 24.1% in 2000 to 30.75% in 2012.
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 20120.00
5.00
10.00
15.00
20.00
25.00
30.00
35.00
24.1327.17
24.03 22.6520.14
30.44 31.66
26.0022.85
26.80 27.4825.62
30.75
Vietnam Gross Domestic Savings (% of GDP) from 2000 to 2012
%
Figure 1: Vietnam Gross Domestic Savings (% of GDP) from 2000 to 2012
Source: http://data.worldbank.org/indicator/NY.GDS.TOTL.ZS
Nguyen Ngoc Son and Tran Thanh Tu (2007) showed that savings from domestic
households took a considerable proportion, by approximately 35%, of the total savings in the
economy. Household saving is defined as the difference between a household’s disposable
income (mainly wages received, revenue of the self-employed and net property income) and
its consumption (expenditures on goods and services). Bank deposits are currently the
primary saving vehicle available to Vietnamese households. The return households earn on
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these bank deposits could therefore potentially influence household saving behavior in a
tangible way.
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 20120
5
10
15
20
25
30
35
40
97.2 7.44 7.5 7.5 7.8 8.25 8.25
14
912
14
9
20
16 15 16 15.5 17
21 22.5
35
21
30
35
21.5
The relationship between Interest rate and Household saving in Vietnam 2000-2012
Interest rate
Household saving (% of GDP)
Figure 2: The relationship between Interest rate and Household saving in Vietnam 2000-2012
2005 2006 2007 2008 2009 2010 2011 20120
5
10
15
20
25
30
7.8 8.25 8.25
14
912
14
9
24.5 24.2 23.3
12.6
20.5
1618.6
20.9
The relationship between interest rate and growth rate of total retail sales of goods and services in Vietnam
2005-2012
Interest rate %
Grow rate of total retail sales %
Axis Title
Figure 3: Interest rate and Growth rate of total retail sales in Vietnam 2005-2012
Take a look at the annual interest rate in Vietnam from 2000 – 2012, we can see that it
generally increases from 9% per year in 2000 to 14% in 2011, but returns to 9% in 2012. In
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2008 and 2009, which see an economic crisis on a global scale, the interest rate go up and
down dramatically. The percentage of Household saving in GDP of Vietnam also tends to
rise from 20% in 2000 to 35% in 2011, and drop to 21.5% in 2012. But the growth of total
retail sales of goods and services in Vietnam from 2005 – 2012, which represents the
spending rate, goes to the opposite way as it decreases from 24.5% to 18.6%. So we can
conclude that the interest rate in this period affect the saving behavior in the same direction
and contrast with the individual expenditure. So, if other factors do not change, the impact of
interest rates on the behavior of individuals is that the real interest rate increase will
encourage more saving than spending. Therefore, the money in circulation will decrease,
which reduce inflation.
How interest rate affects saving can be explained by the substitution and the income
effect. Consumption patterns are constrained by the interest rate 'r' which represents a
payment (or reward) for foregoing current consumption. When the interest rate rise, for a
saver: the reward from saving rise. It becomes relatively less attractive to hold cash and / or
spend. This is the substitution effect – with higher interest rates, consumers substitute
spending for sending money to the bank. However, if interest rates increase, savers see an
improvement in income because they receive higher income payments. A pensioner relying
on interest payments from saving, may feel he can spend more. If the person is lender, the
rise in the interest rate gives the person more income in the future period. Since more future
income increases current consumption. Therefore, people want to consume rather than save.
This is the income effect, works in the opposite direction of the substitution effect. Usually,
the substitution effect dominates. Higher interest rates make saving more attractive. As a
result, supply of money drops, inflation goes down.
2. Impact of interest rate on enterprise investment
The graph below shows the relationship between the interest rate and gross national
investment, including investment of the public sector, private sector(enterprise investment)
and foreign direct investment. In this graph, we use the annual rate and the growth rate of
these sources of investment. The FDI line is excluded, because we do not mention the way
FDI affects inflation in this report.
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2006 2007 2008 2009 2010 2011 2012
-20
-10
0
10
20
30
40
50
The relationship between Interest rate and investment in Vietnam 2006-2012
Interest rate
Public sector
Private sector
Gross national investment
Growth rate, %
Figure 4: The relationship between Interesr rate and investment in Vietnam 2006-2012
The growth rate of public sector’s investment and gross national investment go up
and down together and have an opposite trend with the annual interest rate. When the
interest rate hits the highest point in 2008 and 2011, which is 14%, investment of both public
and private sector goes down. At lower interest rate, for example in 2009, which is 9%,
investment increases dramatically. Overall, the interest rate have a relatively clear impact on
the level of investment by private enterprise rather than state enterprise. The econometric
test below will prove better for this claim.
The econometric models include the following variables:
- The dependent variable: the growth rate of public sector investment (PUB_IN), the
growth rate of private sector (PRI_IN)
- The explanatory variable: the annual rate in Vietnam.
The data is time-series, from 2006 to 2012.
First we have the model assesses the impact of interest rate R on the growth rate of
private sector PRI_IN:
PRI_IN = -2.599654*R12
The results of the model show that the coefficient of R has a negative sign, which is
consistent with the economic theory. The coefficient of the change in interest rates is -2.599
means that when interest rates increase by 1%, then make the investment rate decrease
2.599% , the level of impact in the opposite direction. R2 = 0.6334 means that the change in
the interest rates explain about 63.34% of the variation in the change in the growth rate of
private sector investment, which is somewhat acceptable.
Similarly, we have the model assesses the impact of interest rate R on the growth rate
of public sector PUB_IN:
PUB_IN = -1.258467*R
Model results are also economically significant (interest and investment is in the
opposite direction), the impact is 1.258%. The ability to change interest rates explain the
variability of the change in the growth rate of the public sector investment of about 57%.
The tested model is acceptable.
The result of the study shows that in general, interest rates have the negative effect to
the investments, including the impact of interest rate to investors of private sector investment
is more sensitive than the state sector. This is because, the state now have access to many
more sources of capital outside the banking businesses and enjoy many preferential capital at
lower interest rates than private sector. In addition, acccess to bank loans of the private
sector has been increasingly more favorable in the recent years.
Much business investment is funded wholly or partially by credit(from bank or other
sources). As for business investment, interest rate is the cost of money. It directly affects the
profitability of a company. Overall, businesses invest less when interest rates increase,
because the cost of borrowing money increases. Moreover, an increase in interest rates
means that companies often have to devote more resources to paying interest on their
existing debts, which lowers the amount available for investment.
Higher interest rates reduce the amount of money in circulation because it makes less
people seek loans for new investments while loans are usually made with new money.
Therefore, inflation can be maintain low and steady.
13
Through the above analysis, we can see the interest rates on the money market has a
clear impact relative to saving behavior, personal consumption and business investment and
consistent with theory. As a result, it will have an impact on aggregate demand of the
economy, economic growth and inflation. Therefore, the regulation of central bank interest
rates to influence inflation in this period is necessary.
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CONCLUSION
In conclusion, the report explains the use of monetary policies, in other words,
adjusting the interest rates, to control an economy’s inflation. Contrary to popular belief,
excessive economic growth can be detrimental. At one extreme, an economy that grows too
fast may result in serious inflation, reducing the purchasing power of money. At the other
extreme, deflation happens, stagnating the economy. Thus, changes in the interest rates are
used by the National banks as an instrument to keep the economy in balance.
In general, movements of the interest rates affect two kinds of entities: individuals
(sending money to the bank) and enterprises (borrowing money from the bank). As rates of
interest raised, people tend to increase their bank savings, wishing for more attractive
rewards in return, whilst enterprises are about to borrow less from the banks due to higher
costs. Consequently, the process reduces the money in circulation and staves off inflation.
The case holds right in the conversed situation, when the interest rates are decreased.
With respect to the crucial relationship between interest rates and inflation mentioned
above, Vietnamese government has set up suitable policies in attempt to achieve price
stability and financial balance. This means a lot to its developing economy.
15
REFERENCE1. BUI THI KIM THANH (November 2008). ‘Inflation in Vietnam over the period 1990 –
2007.
2. NGUYEN THI MINH, NGUYEN HONG NHAT, TRINH HONG ANH, PHUNG
MINH DUC, LE THAI SON, National Economics University, Vietnam (2013).
‘Demographics and Saving Behavior of House holds in Rural Areas of Vietnam: An
Empirical Analysis
3. N. GREGORY MANKIW (2011). Macroeconomics, 5th edition.
4. HENRY ALEXANDER MITCHELL – INNES (May 2006). ‘The relationship between
interest rates and inflation in South Africa: Revisiting Fiser’s hypothesis.
5. ROBERT E. HALL. ‘Inflation: Causes and Effects.
6. Data from GENERAL STATISTIC OFFICE OF VIETNAM and THE WORLD BANK.
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