Financial Forces Governments Can Exert 225 TABLE 8 .5 Sample Central Bank Interest Rates Central Bank Interest Rate for April 2014 Bank of England 0.50 Bank of Japan 0.10 European Central Bank 0.25 United States Federal Reserve 0.25 Swiss National Bank 0.00 The Reserve Bank of Australia 2.25 Bank of Canada 1.00 Central Bank of Brazil 11.00 The People’s Bank of China 6.00 Reserve Bank of India 8.00 Bank of Korea (South) 2.50 Bank of Mexico 3.50 Central Bank of the Republic of Turkey 10.00 Source: http://www.fxstreet.com/economic-calendar/world-interest-rates/ Inflation, a financial force external to companies, affects the firm in several major ways. First, the inflation rate determines the real cost of borrowing in capital markets. You’ll recall the Fisher effect from our discussion of exchange rates. When the firm operates in multiple countries, it has multiple currency exposures, and the complexity of dealing with inflation increases because inflation rates vary among countries. When management decides to raise capital, should they use equity or debt? In which capital markets? In what currency? These are critical questions, and inflation rates play a role in the answers. Further, rising inflation rates encourage borrowing (debt), because loans can be repaid in the future with inflated, cheaper money. But high inflation rates also bring high interest rates because banks have to offer more reward to draw in deposits. Then inflation may discourage lending, because lenders may fear that, even with high interest rates, the amount repaid plus interest will be worth less than the amount lent. Thus, you see how the relationship between inflation and interest rates can affect business decisions. And in our discussion of the international Fisher effect we have seen the relationship between currency exchange rate trends and interest rates. So there is a relationship between inflation and currency exchange rates. Inflated currencies tend to weaken. In inflated economies, instead of lending, the money holder may buy something that is expected to increase in value, thereby further fueling inflation. In Brazil during a recent inflationary period, farmers hoarded their crops and then used them in barter for imported farming equipment and Mercedes cars. Lenders have begun to use variable interest rates, which rise or fall with inflation, to shift financial risk to the borrower. This shift requires that the borrower be much more careful about borrowing. The original rate and any future changes are based on a reference interest rate, such as the U.S. prime rate (the rate of interest at which banks lend to their best customers), or the London Interbank Offer Rate (the bank-to-bank interest rate in London—LIBOR). As Table 8.5 suggests, April 2014 interest rates in most countries varied across a small range. This trend may be explained by the integration of financial markets as they become
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