An economic trade-off faced by the Fed in achieving its economic policy objectives.

at
Categories
Tags

Describe an economic trade-off faced by the Fed in achieving its economic policy objectives.
What are recognition and implementation lags? How do these influence security prices?
Why might the Fed’s monetary policy depend on the fiscal policy that is implemented?
Stock market conditions serve as a leading economic indicator. Assuming the U.S. economy is in an expansion, what are the implications of this indicator? Why might this indicator be inaccurate?
Assess the economic situation today. Is the current administration more concerned with reducing unemployment or inflation? Does the Fed have a similar opinion? If not, is the administration publicly criticizing the Fed? Is the Fed publicly criticizing the administration? Explain.
What type of organization issues commercial paper? Given the short-term nature of commercial paper, why would ratings agencies assign ratings to them?
The maximum maturity of commercial paper is 270 days. Why would an organization issue commercial paper rather than longer-term securities, even if it needs funds for a long period of time?
Assume an investor purchased a three-month T-bill with a $10,000 par value for $9,500 and sold it 45 days later for $9,600. What is the yield?
A money market security that has a par value of $10,000 sells for $8,924.70. Given that the security has a maturity of two years, what is the investor’s required rate of return?
A U.S. investor obtains British pounds when the pound is worth $1.30 and invests in a one-year money market security that provides a yield of 4 percent (in pounds). At the end of one year, the investor converts the proceeds from the investment back to dollars at the prevailing spot rate of $1.32 per pound. Calculate the effective yield.

Sample Solution

The Fed faces a critical trade-off between achieving price stability (low inflation) and maximum employment.

  • Lowering interest rates: Stimulates borrowing and spending, boosting economic growth and potentially reducing unemployment. However, it can also lead to higher inflation.
  • Raising interest rates: Discourages borrowing and spending, helping to control inflation. However, it can slow economic growth and potentially increase unemployment.

Recognition and Implementation Lags

  • Recognition Lag: The time it takes for policymakers (like the Fed) to recognize there’s a problem in the economy. Data collection and analysis can take months.
  • Implementation Lag: The time it takes for a policy change (like raising interest rates) to affect the economy. Changes in interest rates can take 6-18 months to fully impact inflation and unemployment.

Impact on Security Prices:

These lags can create uncertainty and impact security prices. For example, if the Fed waits too long to raise rates to combat inflation, investors might sell stocks in anticipation of lower future returns, driving down prices.

Fiscal Policy’s Influence on Monetary Policy

The Fed’s monetary policy can be influenced by fiscal policy (government spending and taxation).

  • Expansionary fiscal policy (increased spending/decreased taxes): Can lead to higher inflation. The Fed might respond by raising interest rates to counteract this.
  • Contractionary fiscal policy (decreased spending/increased taxes): Can help control inflation, potentially allowing the Fed to keep interest rates lower.

Stock Market as a Leading Indicator

A rising stock market often precedes a strong economy and vice versa. This can be a leading indicator for the Fed, providing clues about future economic performance.

Limitations of this Indicator:

  • Stock prices can be volatile and influenced by short-term factors unrelated to the broader economy.
  • Stock market performance can be unevenly distributed, with some sectors thriving while others struggle, making it a less reliable indicator of overall economic health.

Current Economic Situation (July 14, 2024 – Answer is Time Dependent)

Disclaimer: As your question is on July 14, 2024, a real-time assessment of the economic situation is not possible in this answer key. However, I can provide you with a framework to analyze the situation yourself:

  • Look for recent news and data on inflation and unemployment rates.
  • Analyze the Fed’s recent policy decisions and statements.
  • Consider any recent fiscal policy changes implemented by the government.

Based on this information, you can then assess whether the current administration seems more focused on unemployment or inflation, and if the Fed’s priorities seem aligned. You can also see if there’s any public criticism between the two entities.

Issuers and Ratings of Commercial Paper

  • Commercial paper is issued by large, creditworthy corporations to raise short-term funds (typically less than 270 days).

Ratings Agencies:

Even though commercial paper is short-term, ratings agencies like Moody’s and S&P Global assign ratings to them because:

  • Ratings help investors assess the creditworthiness of the issuer and the risk of default.
  • Investors often use ratings as a benchmark when making investment decisions.

Commercial Paper vs. Long-Term Securities

Companies may prefer commercial paper over long-term bonds for several reasons:

  • Lower interest rates: Commercial paper typically offers lower interest rates than long-term bonds.
  • Flexibility: Maturity of commercial paper is shorter, allowing companies to take advantage of potentially lower interest rates in the future when refinancing.
  • Market Conditions: Issuing commercial paper can be quicker and easier than issuing long-term bonds, especially when market conditions are favorable.

T-Bill Yield Calculation

This is a discount yield calculation:

Yield = (Face Value – Purchase Price) / Purchase Price * (Number of Days Held / 360)

  • Face Value = $10,000
  • Purchase Price = $9,500
  • Days Held = 45

Yield = ($10,000 – $9,500) / $9,500 * (45 / 360) = 0.0526 or 5.26% annualized.

Money Market Security Yield Calculation

This is a bond yield formula:

Yield to Maturity (YTM) = (Coupon Payment + (Face Value – Purchase Price)) / Purchase Price / (Number of Years to Maturity) * 2

  • Face Value = $10,000
  • Purchase Price = $8,924.70
  • Maturity = 2 years

This question has been answered.

Get Answer