Monetary Policy: Money, Credit, the Federal Reserve, and Interest Rates
- 1. The Federal Reserve policy makers use of several different tools to influence the money supply and interest rates. Identify and briefly describe these tools. Include in your answer the difference between expansionary and contractionary monetary policies.
What is the relationship between short and long-term interest rates as the time to maturity of the debt increases?
3. For the past 3 years a major department store chain has averaged approximately $10 billion in long-term debt. Their debt is in the form of bonds that have been sold to investment funds and the public (If you are not sure what a corporate bond is look it up on the internet). For the sake of argument, let us assume that either now or one-year from now they will add an additional $5 billion to finance store expansion. This is a given, management has already made this expansion decision and it does not need to be commented on. The objective of management is to issue bonds at the lowest interest rate. Given this objective, should they issue the bonds now or wait for one year if they feel the Federal Reserve will follow:
a. An expansionary policy?
b. A contractionary policy?
The Federal Reserve has the mandate and the capability to create impact on the economy by either decreasing or increasing the supply of money. Controlling the interest rates gives the Fed an upper hand in determining the amount of money that circulates within the economy (Resource center, 2013). One primary tool that it applies in most instances is the sale and purchase of Treasuries, a process generally referred to as ‘open market operations’. This process is similar to direct manipulation of interest rates, since Open market operations can decrease or increase the total amount of money supplied as well as create an impact on interest rates. In this case, if the ‘Fed’, as it is normally referred to, buys bonds in an open market operation, money supply is increased since the bonds are swapped out of the market in exchange for cash which is then made available for circulation. On the other hand, if it sells bonds, money supply is decreased since cash is removed from the economy(Resource center, 2013). It is therefore plausible to say that OMO (open market operation) has a direct influence on money supply. Additionally, it affects interest rates since in the event of buying bonds; the Fed indirectly pushes prices higher as interest rates decrease(Gordon, 2012).
Another tool that the Feds use is the manipulation of interest rates, especially that of short-term nature(Gordon, 2012). This practice targets spurring or lowering of economic activity and the control of inflation rates. When interest rates are lowered, it becomes generally cheaper to borrow money, thus people are encouraged to take loans, and save less. As a result, more money is available for spending, and the total more supplied in the economy also goes up. Conversely, when the Fed lowers interest rates, inflation tends to increase, which is a negative effect of this tool. Because of this reason, monetary manipulation of interest rates is not so much encouraged, but it still plays some role if used judiciously.
Thirdly, the Federal Reserve can adjust the reserve requirements of each bank, which is crucial in determining the reserve levels a bank must be able to hold based on given deposit liabilities. Therefore, based on the required reserve ratio, the bank must be a t a position to hold the required percentage of the deposits within the Federal Reserve in vault cash or in deposits(Lawler, 2007). By making this adjustment, the Fed is able to effectively decrease or increase the amount that can be lent by financial facilities, thereby controlling the amount of money supplied in the economy, as well as interest rates. Additionally, the Fed can resort to influencing the perceptions on the market. Though this is a complicated tool, it has proven to be effective in controlling the amount of money supplied as well as the interest rates used in the economy (Gordon, 2012). It relies on the concept of influencing the perceptions of an investor, which may include the Fed making a direct announcement regarding the status of the economy. This is more often than not, not an east endeavor, but it provides an indirect way for the Fed to accomplish its objectives regarding monetary influence. For instance, the Fed may state that the economy is fast growing and poses a threat of high inflation rates in the future. This would mean that interest rates are expected to increase, and bondholders may move to release their binds in exchange for money. As bonds are sold by investors, prices usually go down while interest rates rise, thus achieving an initial objective of the Feds to increase interest rates.
In the above respect, various tools applied by the Fed are either contractionary or expansionary policies. Contractionary policy comprises a set of tools which are engaged by the government to slow down the growth of an economy and to prevent it from getting overheated (Gordon, 2012). The monetary policy is an example of such a tool, including managing interest rates, money supply, credit flow in and out of the economy, and manipulating currency exchange targets.On the other hand, expansionary policy is used to expand the economy when it is particularly facing a recession or a period of slow economic growth. In a nutshell, expansionary policy causes a decrease in interest rates and an increase in bond prices, while the latter works exactly opposite to it.
The Yield curve provides a logical comparison between short-term and long-term interest rates at the time of maturity. The economy usually faces increase uncertainties in the distant future than in the short-term (Estrella&Trubin 2006). Investors believe min the underlying notion that there is a higher risk of negative future events, than that of the positive future events. Therefore, there is a remarkable difference between the short-term and long-term yields, also referred to as the liquidity spread. Thus, it is reasonable to state that if short-term interest rates are set higher than the long-term rates; an inversion in the yield curve will be noticed. Such incidents are caused by the market’s anticipation of possible fall on interest rates. Therefore, spreads or negative liquidity premiums are occasionally experienced. At the near end of a debt maturity, the anticipation of a possible fall in interest rates causes an inversion in the yield curve, which is generally an indication of an economic depression.
An expansionary policy is usually used by the Federal Reserve to revamp an economy, especially during periods of economic recession and slow economic growth. It means that in such a policy, the Fed would promote borrowing thus lower interest rates, with an aim of increasing the amount of money supplied to the economy. If the management wishes to issues the bonds at the lowest rates, then they would better wait for one year when the Fed would have bought bonds to increase the amount of money in supply, and when interest rates would be generally lower.
On the other hand, contactionary policy is usually used by the Fed to slow down economic growth that is threatening to overheat(Gordon, 2012). Some of the tools used here include reduction in government spending, increase of interest rates, increase of taxes, and other forms of monetary controls that target to reduce the amount of money being supplied in the economy (Lawler, 2007). If the Federal Reserve will follow this strategy, it would be better for the management to issue the bonds now, since it is likely that interest rates would go up, and the Fed would most probably sell its bonds to the public in exchange for cash, subsequently reducing money supply in the economy. This would not serve the purpose of the management as outlined in the objectives of the department store.
List of References
Estrella A. &Trubin M. R. 2006. The yield curve as a leading indicator: Some practical issues. Current issues in economics and finance: Federal Reserve Bank of New York, 12(5), 1-7.Retrieved on 23rd May, 2013 from http://www.newyorkfed.org/research/capital_markets/ycfaq.html
Gordon, D 2012, ‘The Federal Reserve Bank’s New Monetary Policy Tool’, Journal Of Business & Economics Research, 10(9), 533-537.
Lawler, TA 2007, ‘Federal Reserve Policy Strategy and Interest Rate Seasonality’, Journal Of Money, Credit & Banking (Ohio State University Press), 11(4), 494-499.
Resource center, 2013.Daily treasury yield curve rates.Retrieved on 23rd May, 2013 from http://www.ustreas.gov/offices/domestic-finance/debt-management/interest-rate/yield.shtml.