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.

3

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

4

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

7

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.

8

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

9

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

10

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.

11

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.

14

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.

16