Recession Recovery the Effects of Reducing Interest Rates, Essay Example

The principal purpose of the Federal Reserve System, known as the Federal Reserve, is to guarantee maximum employment, even prices and reasonable long-term interest rates. Congress, while retaining oversight, has entrusted this responsibility to the Federal Reserve. In response to inflationary periods, the common economic wisdom would have the Fed reduce interest rates so as to spur economic growth and development within the economy. However, a reduction in interest rates would have considerable impacts on a number of facets of the economy, including (1) Consumer financing for big-ticket items such as autos and homes; (2) the present and future values of annuities; (3) the NPV calculation; (4) the WACC; (5) corporate earnings.

An economy at equilibrium is at the point where amount of goods or commodities demanded by the economy is matched by the suppliers (. When interest rates increase, the cost of production increases, raising the general prices of commodities within the market. Thus causes a shift in the IS curve. This increase in interest rates may be attributed to an increase in government borrowing, a situation known as crowding out. To respond to this shift, government will reduce expenditure effectively reducing the interest rates. This can be done through the reduction in government borrowing. When government reduces the need for foreign liabilities, there is a general reduction in the need for credit within the market. This effectively reduced interest rates within the market. Alternatively, the government can achieve this through the reduction of government expenditure. When government expenditure reduces, the amount of private investments increases, effectively lowering the prevailing interest rates

The Federal Reserve operates the Central Bank, thus controlling the nation’s money supply. The economy is affected in more ways than supply and demand. Both fiscal policy of the government and the monetary policy of the Federal Reserve contribute to the overall economy. Each has the potential to affect the economy. Both have advantages and disadvantages. The Federal Reserve can be more effective in slowing down the economy in order to promote more employment and slow down inflation with its monetary policies by setting a base interest rate. The government must raise taxes or reduce spending in order to slow down the economy. Neither of these actions is politically popular

Consumer Financing for Big-Ticket Items

In response to growing inflation, the Fed will opt to adopt a loose monetary policy where no official rates are applied to commercial banks. This would create a situation where interest rates within the real estate industry will plummet. This would allow consumers to be able to purchase homes and take out mortgages at a lower cost. This would cause a considerable increase in the value of assets while credit and risk-taking will increase to higher levels. When low rates are maintained for extended periods of time in a bid to save the collapsing economy, the Fed would inadvertently increase the demand for housing. Extended period of these conditions would create a price bubble. Low home mortgages would be characterized by a glut in global savings.

Present and Future Values of Annuities

With a decrease in interest for the U.S, one can predict an outward shift in aggregate supply to correspond to an annual rate of growth in potential output or production in different economic sectors. It adjusts federal funds rate based on evolving economic developments. Any variation in the federal funds rate can affect stock prices, foreign exchange rates and short-term interest rates. When interest rates are high, people tend to invest in interest-bearing bonds and economize on their other money holdings. As a result, the amount of aggregate demand is less.

The pure Expectations Theory is the simplest theory on interest rates. This theory is founded on the premise that the term structure or the maturity period of a security contract is based on the shorter term maturity periods or segments for the determination of the interest rates and pricing of longer term maturities (Brealey, Myers, & Marcus, 2012). The theory is based on the assumption that higher maturities’ yields tally with future realizable rates and that these yields and realizable rates are compounded from the yields that are generated from shorter term maturities. This theory would fundamentally assume that purchasing a 10 year bond would be equivalent to purchasing two 5 year bonds consecutively. This means that an investor would realize the same risks when buying two 5 year bonds consecutively as buying a 10 year bond at the present.

In essence, this theory should be correct. This is because the U.S. government bonds, the lent amount and the interest rate of return are what give rise to the rewards and risks associated with the bond regardless of the maturity period (Horngren, Datar, & Rajan, 2012). The transaction itself holds little to no risks of default.

The Pure Expectations Theory would also presume that the future rates that are realizable in time are the same or are in tandem with the expectations of the future rates (Horngren, Datar, & Rajan, 2012). This theory analyzes the market to forecast the demand and supply this is because it is also founded on the premise that the market has a perfect environment and the expectations within the market environment is the only facet determining the future prices.

Analysis

On the short term, 2yrs, A-Rated Municipal bonds have a much stronger yield as compared to AA-Rated Municipal Bonds, AA-Rated Municipal Bonds, AAA-Rated Corporate Bonds, AA-Rated Corporate Bonds, A-Rated Corporate Bonds and U.S. Government bonds. This can be attributed to the fact that on the short term, these bonds have a tax equivalent yield for 28% federal income tax.

Longer term bonds all predict similar trend in yield. A-Rated U.S. Corporate bonds have a higher yield rate as compared to AAA-Rated Corporate Bonds, AA-Rated Corporate Bonds, AAA-Rated Municipal Bonds, AA-Rated Municipal Bonds, AA-Rated Municipal Bonds, and U.S. Government Bonds. However, all the yield rates for these securities adhere to the Pure Expectations theory. This is because, as depicted, as the interest rates for longer term securities surged, so did the interest rates for shorter term securities in the case of 10-year and 5-year bonds. However, this is not the case for 2-year securities as it is near impossible to achieve a perfect market with a perfect environment.

The Weighted Average Cost of Capital (WACC)

The Weighted average cost of capital is a crucial indicator of the profitability of a company or project, especially when compared against returns. The WACC is thus a vital component of current and future financial performance. The calculation of the WACC requires that interest rates be taken into consideration. When interest rates decline, the weighted average cost of capital for a company reduces. This is because the cost of acquiring capital has reduced.

Weighted Average Cost of Capital (WACC) Formula and Calculation

• WACC = [Debt / (Debt + Equity)* Cost of Debt] + [Equity / (Equity + Debt) * Cost of Equity]
• WACC = [Weighted Debt * Cost of Debt] + [Weighted Equity * Cost of Equity]
• Cost of Debt = After Tax Cost of Debt
• After Tax Cost of Debt = (1 – Tax Rate) * Cost of Debt (Brealey, Myers, & Marcus, 2012)

Net Present Value (NPV)

The NPV provides an investor with a gauge on potential investments, helping to determine the investment alternatives that can realize the desired yield. Corporate Earnings Net Present Value refers to the difference between the present cash flow and out flows in the business. It brings a comparison of the value of the dollar at the present and in the future. NPV plays a very crucial role as it’s considered in making decision concerning investment whether valuable or invaluable (Hirschey and Bentzen). It is obtained by getting the difference between the present value of all the incomes expected from the project and the initial value of the investment. It gives the position of the project, relative to the expected rate of return that is the discounting rate. A decrease in the discounting rate would lead to a decrease in the NPV of a given project or investment. This is depicted in the example below

Corporate Earnings

The cost of capital is directly proportional to the interest rates within an economy, largely influenced by inflation. Therefore, if inflation is not reduced, then the cost of capital will remain high, locking out the economy from potentially risky, yet rewarding projects or investments. As a result, an increase in interest rates would make capital generally more difficult to access. This is because the cost of accessing capital would have gone up. This reduces corporate earnings as profit per dollar of capital invested reduces compounded by the general reduction of demand.

In conclusion, fiscal policy can be more effective in fostering economic growth by increasing Government spending and lowering taxes. In this example, fiscal policy can be more effective than monetary policy. While the Federal Reserve will use monetary policy to promote growth, banks may be reluctant to lend at low interest rates and businesses may be reluctant to invest in recessionary times. Consumers may be reluctant to borrow, unsure about long-term economic conditions. It follows that monetary policy will probably not promote growth in times of recession while fiscal policy has a greater chance in creating improvement in such times. Monetary policy works to slow the economy in times of rapid expansion while fiscal policy works to grow the economy. Both policies have the ability to promote economic activity and preserving price stability in their own ways. Probably the action that affects aggregate demand most is the Federal Reserve movement of interest rates.

References

Brealey, R. A., S. C. Myers and A. J. Marcus. Fundamentals of corporate finance. New York: McGraw-Hill/Irwin, 2012.

Hirschey, Mark and Eric Bentzen. Managerial economics. Andover: Cengage Learning, 2014. Print.

Horngren, C. T., S. M. Datar and M. V. Rajan. Cost accounting: A managerial emphasis. Upper Saddle River: Pearson/Prentice Hall, 2012.