FIN FPX 5710 Assessment 2

Introduction

This paper examines the interactions between monetary policy, interest rates, and inflation. It examines the ways in which changes in monetary and fiscal policies impact the U.S. economy during periods of high inflation. Moreover, it examines which theoretical model is most appropriate when looking at term structure interest rates among the Expectations Theory, Liquidity Preference Theory, and Preferred Habitat Theory.

Monetary Policy, Interest Rates, and Inflation

Inflation is a general increase in prices, resulting in a decrease in the purchasing power of money as every dollar of income buys less goods and services (McConnell et al., 2021, p. 567). Inflation causes include cost-push inflation, such as increased material cost; demand-pull inflation because of higher consumer demand; and overly expansionary fiscal and monetary policy that boosts discretionary income (Investopedia, 2021). Inflation and interest rates have an inverse relationship such that as inflation increases, interest rates increase as well. The Federal Reserve attempts to manage inflation while maintaining high employment and price stability. Employment and output stability, economic growth, financial market stability, interest rate stability, and foreign exchange market stability are the main goals of monetary policy (Mishkin, 2019, p. 371). In times of recession, the Fed adopts an expansionary monetary policy by increasing the supply of money. In instances of inflation, which is more than the optimal 2%, the Fed employs a restrictive monetary policy, characterized by decreasing the reserves of banks and increasing the interest rates in order to decrease spending and investing (McConnell et al., 2021, p. 717).

Fiscal Policy Versus Monetary Policy Impacts on Inflation

Fiscal policy refers to the changes in government expenditure and government revenue with the aim of achieving full employment, price stability, and economic growth (McConnell et al., 2021, p. 647). In a period of inflation, contractionary fiscal policies appear in the decrease in government expenditure and taxation for the purpose of reducing aggregate demand (McConnell et al., 2021, p. 649). Discretionary fiscal actions and expenditure and tax adjustments are used to offset inflation, with the focus on managing consumer and business spending. Built-in stabilizers such as automatic tax income, which responds inversely with a change in GDP, provide stability to the economy. During periods of high inflation, increased discretionary tax increases can be a necessity (McConnell et al., 2021). The Federal Reserve supplements these fiscal measures by tightening monetary policy, i.e., raising interest rates and reducing the money supply through open market operations. The Fed can sell government securities, raise the legal reserve ratio, raise the discount rate, and raise interest rates on excess reserves to fight inflation (McConnell et al., 2021, p. 724).

FIN FPX 5710 Assessment 2:Term Structure Theories

This discussion addresses three bond term structure theories: Expectations Theory, Liquidity Preference Theory, and Preferred Habitat Theory.

The theories inform us about the determination of bond interest rates of bonds with various maturities under the condition that bonds are of equal risk, liquidity, and tax characteristics but with varying maturities (Mishkin, 2019).

The yield curve, which plots these bond yields, has an upward slope when long-term rates exceed short-term rates and a downward slope (reversed) when the latter is true (Mishkin, 2019, p. 125).

The Expectations Theory assumes that long-term interest rates are equal to the weighted average of expected short-term interest rates over the life of the bond. This theory assumes that bonds of different maturities are ideal substitutes, and changes in interest rates reflect expected changes in short-term rates (Mishkin, 2019, p. 127). According to this theory, interest rates on bonds of different maturities will tend to move together in the long term, 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 fails to explain why the yield curve is typically in an upward-sloping direction (Mishkin, 2019, p. 130).

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

Under the Liquidity Preference Theory, long-term interest rates are a function of the average of predicted short-term interest rates plus a liquidity premium reflecting the demand and supply of bonds. It makes an assumption of working that different maturities’ bonds are substitutes, but imperfect substitutes. Investors prefer shorter-duration bonds due to reduced interest rate risk and need a liquidity premium to engage in longer-duration bonds (Mishkin, 2019, p. 131).

All three characteristics of interest rates are discussed in the theory; for example, the persistent upward slope of yield curves results from the liquidity premium rising with the maturity of bonds (Mishkin, 2019, p. 133). The Preferred Habitat Theory, which is very similar to the Liquidity Preference Theory, is the argument that investors prefer to hold bonds with specific maturities or “habitats” and require a higher expected return in order to invest outside their preferred range of maturities. This theory also explains all three characteristics of interest rates, as well as the Liquidity Preference Theory (Mishkin, 2019, p. 133). These theories both come into play as they encompass all three behavioral characteristics of interest rates and yield curves.