FIN FPX 5710 Assessment 2 Economic Foundations in Financial Decision Making: Inflation Analysis

FIN FPX 5710 Assessment 2 Economic Foundations in Financial Decision Making: Inflation Analysis

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Capella university

FIN-FPX5710 Economic Foundations for Financial Decision Making

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Introduction

This report examines the interconnections between monetary policy, interest rates, and inflation. It evaluates how modifications in fiscal and monetary policies impact the U.S. economy during periods of high inflation. Furthermore, it assesses which theoretical framework is most pertinent when analyzing term structure interest rates among the Expectations Theory, Liquidity Preference Theory, and Preferred Habitat Theory.

Monetary Policy, Interest Rates, and Inflation

Inflation denotes a general increase in prices, resulting in a decline in the purchasing power of money, as each dollar of income buys fewer goods and services (McConnell et al., 2021, p. 567). The causes of inflation include cost-push factors, such as rising material costs, demand-pull inflation arising from increased consumer demand, and excessively aggressive expansionary fiscal and monetary policies that boost discretionary income (Investopedia, 2021). The relationship between inflation and interest rates is inverse; when inflation rises, interest rates typically increase as well.

The Federal Reserve strives to regulate inflation while ensuring high employment and maintaining price stability. The key objectives of monetary policy encompass employment and output stability, economic growth, financial market stability, interest rate stability, and foreign exchange market stability (Mishkin, 2019, p. 371). In times of recession, the Fed implements an expansionary monetary policy by increasing the money supply. Conversely, when inflation surpasses the targeted 2% rate, the Fed may resort to a restrictive monetary policy, which involves decreasing bank reserves and elevating interest rates to curtail investment and spending (McConnell et al., 2021, p. 717).

Fiscal Policy Versus Monetary Policy Impacts on Inflation

Fiscal policy refers to the adjustments in government spending and tax collection aimed at achieving full employment, price stability, and economic growth (McConnell et al., 2021, p. 647). In periods of inflation, contractionary fiscal policies are introduced, including cuts in government spending and increased taxation to reduce aggregate demand (McConnell et al., 2021, p. 649). Discretionary adjustments in government spending and taxes are employed to tackle inflation, with a focus on curtailing consumer and business expenditures. Built-in stabilizers, such as tax revenues that automatically adjust in response to changes in GDP, contribute to economic stabilization.

During periods of significant inflation, discretionary tax increases may be necessary (McConnell et al., 2021). The Federal Reserve complements these fiscal measures by tightening monetary policy, which involves raising interest rates and reducing the money supply through open market operations. The Fed may sell government securities, raise the legal reserve ratio, increase the discount rate, and elevate interest rates on excess reserves to combat inflation (McConnell et al., 2021, p. 724).

Term Structure Theories

This section reviews three theories concerning the term structures of bonds: Expectations Theory, Liquidity Preference Theory, and Preferred Habitat Theory. These theories provide insights into how interest rates for bonds with varying maturities are determined, under the assumption that bonds share identical risk, liquidity, and tax characteristics but differ in their maturities (Mishkin, 2019). The yield curve, which plots these bond yields, displays an upward slope when long-term interest rates exceed short-term rates and a downward slope (inverted) when the opposite is true (Mishkin, 2019, p. 125).

The Expectations Theory asserts that long-term interest rates are equivalent to the average of anticipated short-term interest rates throughout the bond’s duration. This theory assumes that bonds with different maturities are perfect substitutes, and variations in interest rates result from expected changes in short-term rates (Mishkin, 2019, p. 127). According to this theory, interest rates on bonds of varying maturities tend to move in tandem over time, with yield curves sloping upward when short-term rates are low and inverting when short-term rates are high (Mishkin, 2019, p. 129). However, it falls short in explaining why yield curves generally exhibit an upward slope (Mishkin, 2019, p. 130).

FIN FPX 5710 Assessment 2 Economic Foundations in Financial Decision Making: Inflation Analysis

The Liquidity Preference Theory posits that long-term interest rates equal the average of expected short-term interest rates plus a liquidity premium that reflects the supply and demand dynamics for bonds. It assumes that bonds with different maturities are substitutes, albeit not perfect ones. Investors prefer shorter-term bonds due to lower interest rate risks and demand a liquidity premium to hold longer-term bonds (Mishkin, 2019, p. 131). This theory accounts for all three characteristics of interest rates, including the consistent upward slope of yield curves, which is attributed to the liquidity premium rising with bond maturity (Mishkin, 2019, p. 133).

The Preferred Habitat Theory, which is closely aligned with the Liquidity Preference Theory, contends that investors favor bonds of specific maturities or “habitats” and require a higher expected return to invest outside their preferred maturity range. This theory similarly explains all three characteristics about interest rates, much like the Liquidity Preference Theory (Mishkin, 2019, p. 133). Both theories are relevant as they encompass all three behavioral aspects of interest rates and yield curves.

References

Investopedia. (2021). Inflation definition. https://www.investopedia.com

McConnell, C. R., Brue, S. L., & Flynn, S. M. (2021). Economics: Principles, problems, and policies (22nd ed.). McGraw-Hill Education.

FIN FPX 5710 Assessment 2 Economic Foundations in Financial Decision Making: Inflation Analysis

Mishkin, F. S. (2019). The economics of money, banking, and financial markets (12th ed.). Pearson.