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

Introduction

This report examines the intricate relationships between monetary policy, interest rates, and inflation. It delves into how shifts in fiscal and monetary policies can impact the U.S. economy, particularly during periods of high inflation. Additionally, the report evaluates the most pertinent theory regarding the term structure of interest rates, comparing the Expectations Theory, Liquidity Preference Theory, and Preferred Habitat Theory.

Monetary Policy, Interest Rates, and Inflation

Inflation represents a general rise in prices, diminishing the purchasing power of money as each dollar buys fewer goods and services (McConnell et al., 2021, p. 567). Several factors drive inflation, including cost-push factors like rising material prices, demand-pull inflation resulting from increased consumer demand, and expansionary fiscal and monetary policies that heighten discretionary income (Investopedia, 2021). An inverse relationship exists between inflation and interest rates, with the Federal Reserve (the Fed) seeking to control inflation while maintaining high employment and price stability. The key objectives of monetary policy include employment and output stability, economic growth, financial market stability, interest rate stability, and foreign exchange market stability (Mishkin, 2019, p. 371).

During economic recessions, the Fed employs expansionary monetary policy, increasing the money supply. Conversely, when inflation exceeds the 2% target rate, the Fed adopts restrictive monetary policy, reducing bank reserves and raising interest rates to curb investment and spending (McConnell et al., 2021, p. 717).

Fiscal Policy vs. Monetary Policy Impacts on Inflation

Fiscal policy, encompassing changes in government spending and tax collections, aims to achieve full employment, price stability, and economic growth (McConnell et al., 2021, p. 647). During inflationary periods, contractionary fiscal policies are implemented, reducing government spending and raising taxes to lower aggregate demand (McConnell et al., 2021, p. 649). Discretionary adjustments in government spending and taxes also play a role in curbing inflation, primarily by reducing consumer and business expenditure. Automatic stabilizers, such as fluctuating tax revenues based on GDP changes, also contribute to economic stability. In times of significant inflation, discretionary tax increases may be necessary (McConnell et al., 2021).

The Federal Reserve complements these fiscal measures by tightening monetary policy, involving higher interest rates and reduced money supply through open market operations. These measures include selling government securities, raising the legal reserve ratio, increasing the discount rate, and adjusting interest rates on excess reserves (McConnell et al., 2021, p. 724).

Term Structure Theories

This section examines three theories that explain the term structure of interest rates: the Expectations Theory, Liquidity Preference Theory, and Preferred Habitat Theory. These theories focus on how interest rates for bonds of different maturities are determined, assuming that bonds have the same risk, liquidity, and tax characteristics but differ in maturity (Mishkin, 2019). The yield curve, which plots bond yields, reflects these differences, with an upward slope indicating higher long-term interest rates and a downward slope showing higher short-term rates (Mishkin, 2019, p. 125).

The Expectations Theory posits that long-term interest rates represent the average of expected short-term interest rates over the bond’s life. This theory assumes bonds of different maturities are perfect substitutes, and differences in interest rates are due to anticipated variations in short-term rates (Mishkin, 2019, p. 127). It explains why interest rates for bonds of varying maturities often move together and why yield curves typically slope upwards when short-term rates are low but invert when short-term rates are high (Mishkin, 2019, p. 129). However, it does not fully explain why yield curves tend to slope upwards (Mishkin, 2019, p. 130).

The Liquidity Preference Theory suggests that long-term interest rates equal the average expected short-term rates plus a liquidity premium, which accounts for supply and demand conditions in the bond market. While bonds of different maturities are substitutes, they are not perfect substitutes. Investors tend to prefer shorter-term bonds due to their lower interest rate risk, demanding a liquidity premium for holding longer-term bonds (Mishkin, 2019, p. 131). This theory accounts for the consistent upward slope of yield curves, driven by the increasing liquidity premium with bond maturity (Mishkin, 2019, p. 133).

Closely related to the Liquidity Preference Theory, the Preferred Habitat Theory argues that investors have preferred bond maturities or “habitats&r