FIN FPX 5710 Assessment 2 Economic Foundations in Financial Decision Making: Inflation Analysis FIN-FPX5710 Economic Foundations for Financial Decision Making

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Introduction

This report analyzes the relationships between monetary policy, interest rates, and inflation. The analysis covers how changes in fiscal and monetary policy can affect the U.S. economy in times of high inflation, along with an evaluation of which theory is most relevant when considering term structure interest rates among the Expectations Theory, Liquidity Preference Theory, and Preferred Habitat Theory.

Monetary Policy, Interest Rates, Inflation

Inflation refers to the general rise in prices, meaning each dollar of income buys fewer goods and services, thus weakening the purchasing power of money (McConnell et al., 2027, p. 567). The drivers of inflation include cost-push factors, such as rising material prices, demand-pull inflation where consumer demand increases, and overly aggressive expansionary fiscal and monetary policies, which increase discretionary income (Investopedia, 2021). Inflation and interest rates are inversely related. The Federal Reserve aims to control inflation while ensuring high employment and price stability. The objectives of monetary policy are employment and output stability, economic growth, financial market stability, interest rate stability, and foreign exchange market stability (Mishkin, 2019, p. 371). During a recession, the Fed employs an expansionary monetary policy, increasing the money supply. When inflation exceeds the target rate of 2%, the Fed may adopt a restrictive monetary policy, decreasing bank reserves and raising interest rates to reduce investment and spending (McConnell et al., 2021, p. 717).

Fiscal Policy vs. Monetary Policy Impacts on Inflation

Fiscal policy involves changes in government spending and tax collections aimed at achieving full employment, price stability, and economic growth (McConnell et al., 2021, p. 647). During inflationary periods, contractionary fiscal policies are adopted, including reductions in government spending and increased taxes to lower aggregate demand (McConnell et al., 2021, p. 649). Discretionary changes in government spending and taxes are used to combat inflation, with a focus on reducing consumer and business spending. Built-in stabilizers, such as tax revenues that adjust automatically in response to changes in the GDP, also help stabilize the economy. During periods of significant inflation, discretionary tax increases may be warranted (McConnell et al., 2021). The Federal Reserve complements fiscal actions by tightening monetary policy, which involves increasing 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 raise interest rates on excess reserves to control inflation (McConnell et al., 2021, p. 724).

Term Structure Theories

This section evaluates three theories of bond term structures: the Expectations Theory, Liquidity Preference Theory, and Preferred Habitat Theory. These theories explain how interest rates for bonds of different maturities are determined, assuming that bonds have identical risk, liquidity, and tax characteristics but differ in maturity times (Mishkin, 2019). The yield curve plots these bond yields, where an upward slope indicates long-term interest rates are higher than short-term ones, and a downward (inverted) slope indicates the opposite (Mishkin, 2019, p. 125).

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

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

The Liquidity Preference Theory suggests that long-term interest rates equal the average of expected short-term interest rates plus a liquidity premium that reflects supply and demand conditions for bonds. It assumes bonds of different maturities are substitutes, though not perfect substitutes. Investors prefer shorter-term bonds due to lower interest rate risk and demand a liquidity premium to hold longer-term bonds (Mishkin, 2019, p. 131). This theory explains all three facts about interest rates, including the consistent upward slope of yield curves due to the liquidity premium rising with bond maturity (Mishkin, 2019, p. 133).

The Preferred Habitat Theory, closely