Money supply and interest rates in financing decisions

¶ … tactics that the Federal Reserve uses to manage the economy. The Federal Reserve has a mandate to manage the overall health of the economy (usually GDP), the inflation rate and the unemployment rate. To strike the right balance, it utilizes a number of different techniques. The three main ones are open market transactions, the discount rate, and reserve requirements. All three of these can be used as part of either an expansionary or contractionary strategy.

An expansionary strategy is one that seeks to stimulate economic growth. In general, some degree of economic growth is always desirable. Expansionary policy encourages business investment or it pumps money into the economy. By altering the supply and cost of money, the Federal Reserve can encourage business investment, but also to a lesser degree consumer spending. Expansionary strategy should increase the GDP, increase inflation and lower the unemployment rate.

At times, however, the economy could grow too rapidly. When that occurs, inflation rate could be too high, eroding savings and thereby providing a disincentive to invest. Normally, GDP growth cannot be too high and unemployment too low, so the inflation rate being too high is almost always the key motivator for contractionary monetary policy. Contractionary policy is that which seeks to slow the rate of economic growth -- it is never to actually contract the size of the economy (i.e. bring about a recession). By increasing the cost of money or by reducing its supply in the market, the Federal Reserve can slow growth in the economy.

The first tool that the Fed uses is open market transactions. This typically involves the buying or selling of short-term Treasury securities. When the Fed buys Treasuries, this is an expansionary policy because the Fed is pumping money into the banking system, which sells the Treasuries to the Fed. When the Fed sells Treasuries, companies in the banking system buy them. This pulls money out of the banking system, thereby reducing the supply of money in the economy. Normally, open market transactions are conducted with short-term Treasuries, but in the past few years the Fed has tried to adjust the yield curve and provide additional stimulus to the market by buying back longer-term Treasuries or eve mortgage-backed securities.

The second tool that the Fed uses is the discount rate. The discount rate reflects the cost of money, as it is the rate that the Fed charges banks. The banks then base their own rates on the discount rate. When the discount rate is low, this reflects expansionary policy. A low cost of money encourages firms to invest. The mechanism is simple -- firms evaluate projects on the basis of their profitability and the cost of money is usually a factor in that decision. Firms calculate their own discount rates in part based on the risk free (Fed) rate, especially when they use the capital asset pricing model. Thus, the lower the discount rate, the lower the rate at which firms will evaluate potential projects. The lower the discount rate, the more profitable future projects will be. Thus, when the discount rate is lower, more projects will be approved, thereby creating the link between the discount rate and business investment. When the discount rate is high, this represents contractionary policy because fewer projects will be accepted, slowing the rate of growth in the economy.

Finally, the Fed can affect the supply of money in the economy not just through open market transactions but also through the reserve requirements. This tool is not used often, but could be. Banks take in deposits, and the reserve requirements are the funds that need to be set aside to ensure the health of the banking system. The higher the reserve requirements, the less money the banks have to lend. Remember that there is a connection between the amount of money in the economy and the cost of money in the economy -- like everything else money is governed by the rules of supply and demand. Thus, when reserve requirements are high, this takes money out of the economy and is therefore contractionary policy. When reserve requirements are low, this puts more money into the economy and is therefore expansionary monetary policy.

2. The relationship between short-term and long-term rates is that the longer the term, the higher the rate. This is a normal relationship between time and the cost of money. In general, the longer the term the greater the risk that the rates will change between today and the maturity of a security. Since time is related directly to risk, longer-term securities need to pay more than short-term. For example, we can be reasonably sure that rates will not increase much in the next three months, but in the next three years the economy might improve such that rates would need to be increased significantly. Holders of longer-term securities need to be compensated for this additional risk. This is what is considered a normal yield curve, and that is the current situation today.

If longer-term yields are lower than shorter-term yields, that is what is known as an inverse yield curve. An inverse yield curve reflects investor sentiment that while the economy is performing well at the moment it is not expected to perform as well in the longer-run and the Fed will need to lower the discount rate in the longer-run in order to stimulate the economy. At present, the yield curve is not inverted.

3. a. If they believe that the Fed will pursue an expansionary policy in a year from now, they should wait to issue the bonds. The reason is that the cost of issuing that debt will be just as low as today (almost nothing), so that the company will save itself the cost of a year's debt by waiting.