Introduction
The institution that controls the United States economy by implementing the monetary policy is the Federal Reserve. The economy is controlled through interest rate adjustments. Through the regulation of the financial institutions, it has a huge command on the country’s economy. All this effort is made by the Federal Reserve to control the amount of inflation that can be experienced by the economy at a particular point. The key reason for the formation of the Federal Reserve was formed was to address banking panics. The Federal Reserve System is a legally owned private enterprise belonging to member commercial banks. The Federal Reserve in U.S. in the period between 2002 and 2004 adopted an expansionary monetary policy where the interest rates were reduced from 2.75 percent on 1 January 2002 to 2 percent in 1 January 2004, the move was aimed at reducing unemployment rate by encouraging businesses and individuals to take loans from the banks and engage in investment activities especially in housing.
The policy saw a positive response from the target parties where investments especially in housing increased greatly. The trend in investment rates and employment rate, however, increased at decreasing rate until the year 2008 when the policy could not trigger further positive impact on the economy but led to an economic recession (Krueger, 2012). The Federal Reserve rates were further reduced from 6.25 percent on 1 January, 2007 to 5.25 percent in 1 January, 2008. It has been argued that the low interest rates adopted as from the year 2002 led to the financial crisis in U.S. and which later led to worldwide Great Recession in 2008.
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In the event the Fed settles for raising interest rates next financial year, what effect would raising rates have upon Consumer financing for big-ticket items such as autos and homes
The period beginning early 2007 saw negative impacts of the policies such as, the flow of credit vital for both small and large investments such as in housing declined. The government used the authority to help banks and financial institutions, a decision which also targeted creating jobs and revive the GDP. The strategies employed to rescue the banking sector, housing sector, and auto industry were not popular but helped recover most of money to banks.
The home and auto sector are said to have a high sensitivity to the interest rate policies the Federal Reserve adopts. This is because consumer usually takes loans to acquire these items and any policy on the interest rates has high impacts on them. The EMI the individual the duration of the loan is said to be influenced by two factors which are the loan term and the rate of interest the bank provides for the loan. People will want to borrow, and disposable income of people with mortgages will increase.
EMI = (L*i) * {(1+i) > N/ [(1+I) > N]-1} in which l is the amount of loan, i= the interest rate per month and N is the period in monthly terms.
If interest rate reduces, there will be increased growth of total demand which will lead to increased inflation. Lower interest rate will help increase borrowing by the consumer. This will happen due to reduced cost of borrowing, which will encourage consumers from spending and borrowing. People will want to borrow, and disposable income of people with mortgages will increase. The decline in mortgage interest payments will increase homeowners’ real ‘effective’ disposable finances and their ability to spend.
Modifications in the real interest rates sway the demand for home and autos since they alter borrowing costs making loans available and the wealth of households. High interest rates mean that consumers will no have much disposable income thus they reduce their spending. The interest rates coupled with high standards of lending makes banks to have few loans. This affects consumers, farmers and businesses that in turn cut back spending on equipment slowing productivity and leading to unemployment. The high interest will mean that consumers will not get mortgage loans and will not be able to own home and autos which will in turn affect the automobile industry leading to them laying down workers. A decrease in interest rate means that those who want to borrow money enjoy interest rate cut. Conversely, those who loan out money or buy securities, for example, bonds have less reduced chances of making income from their interest. A decrease in interest rates makes investors to transfer finances away from the bond market to equity market. This can make an enterprise to enjoy the capability to finance expansion at cheap rate, and this can increase future earning potential, and this leads to a higher price of the stock.
Monetary policy by Federal Reserve and how the future will be affected by interest rates
The full adoption of the fiscal policy by the central banks and federal reserves also aims at ensuring high employment levels, triggering economic growth, sustaining stability in the financial markets, stabilizing the interest rates and developing coherence in the foreign exchange markets.
Monetary policy mainly increases money supply which later affects the output. The banks can raise demand through monetary policy. The fall in aggregated demand price level and output in the short run will cause a change in expectation, and this will cause wages, prices to adjust. Monetary policy uses open market operation to affect the money supply through the purchase and selling of bonds (Isaac, 2009). Open market is used to influence the supply of bank reserves, and it contains reserve purchases and sales of financial instruments. The first phase is to predict the future inflation. This can be done through looking into different economic statistics and see if the economy is overheating. In case inflation is forecasted to increase beyond the target then there will be an increase in interest rate. If interest rate increases there will be reduced growth of total demand that will lead to reduced inflation. Higher interest rates will help in reduction of spending by the consumer. This will happen due to increased cost of borrowing, which will discourage consumers from spending and borrowing.
Low interest rate will make people to be more willing to spend than save which will increase consumption and hence increase in output. When the government purchases bonds, the reserve in the banking sector is increased and hence money supply increases in the economy. In case the fed sells, the stock there is decrease in the money supply, in the country. Through the increase in the bank, reserve requirement by the fed makes excess reserve in the banks to reduce hence reduced money supply in the economy.
Inflation targeting
The strategy of the monetary policy aims at keeping inflation within a desired range under specific definitions such as the Retail Price Index (RPI) and Consumer Price Index (CPI). The inflation targeting approach is mostly achieved through adjustments in the interest rate target a responsibility of the Federal Reserve. The Federal Reserve uses the interbank rate which is the ratio at which banks lend to each other overnight to ensure a continuous cash flow which is referred to as the cash rate
How interest will affect the value of annuities
Annuities are continuous fix payments one pays or is paid at a specified frequency in a given period of time. There ordinary annuities and due annuities. The ordinary annuities require payments at the end of each period (coupon payments which are paid every six moths until the date of bond maturity), while the annuity due require payment at the beginning of each period (rent). Monetary policy uses open market operation to affect the money supply through the purchase and selling of bonds. Open market is used to influence the supply of bank reserves, and it contains reserve purchases and sales of financial instruments. Buying bonds by the central bank there are more money in circulation while when it sells bonds there will be no enough money in circulation.
The present value of annuities is very sensitive to changes in the interest rate. This is because the MIR is merely applied on the accumulated capital and does not affect future benefits to be paid. This means that there is no compound interest in the short run. The federal technical rate of interest discounts all future cash flows and enters through interest rate effects in calculating the present value of annuities.
Analysis of the future and present value of annuities
The future over-all value of a lump sum is computed by adding the accumulated interest earned to the present value which is the initial investment over the concerned period. Th
is is the amount of money today that is equivalent to the given future amount when taking into account the rate of revenues that can be generated on the present value. The greater interest rates and, the more into the future the fiscal flow occurs, the lower its present value.
How Interest Will Affect the NPV Calculation as well as Corporations Earnings
If the value of interest level increases the assets’ value which reflects a string of expected future cash flows will in turn decrease and when the interest rate level decreases, the value of assets will in turn increase. On the hand, the value of liabilities which reflects future cash outflows will increase to the negative when interest as the level increases. The sensitivity of interest rate on assets and liabilities differ meaning that the corporation will have an interest gap and that its equity position will be affected by any changes in the interest rate level. During high interest periods, when the net cash flows generated by a corporation are high, the NPV of the cash flows will be high. When the accounts payable are high, it is considered safe for business since they increase cash flows thus increasing the NPV. This means that anything which has a positive increase on the cash flow will in turn increase the NPV.
Adjusted NPV = base case NPV + NPV of financial side effects associated with the project.
If a corporation relies on debt financing either wholly or partly, the high interest rates will automatically increase the cost while reducing earnings (Kapil, 2011). Even when the company does not depend on borrowing it is probable that some of its customers depend on borrowing meaning thus high rates will reduce their spending thus reducing the sales of the company leading to low earnings. The present theory of profit implies that changes in the interest rate though affect the size of the company sector profit margin; they have little or no sway at all on the level of the company sector investment.
Interest rate risk
The interest rate probabilities is associated with the fixed income securities. This means that a change in interest rate affects the income securities. There is an opposite link between interest rates movement and the market value of fixed income security. When interest rates rise, in the slighest way, the market value of the fiscal investments like bonds and preferred stocks reduces. This creates uncertainty and volatility in the price of the fixed income securities.
- Andersen, T. J., & Schroder, P. W. (2010). Strategic risk management practice: How to deal effectively with major corporate exposures. Cambridge, UK: Cambridge University Press.
- Isaac, A, G. (2009). ‘Monetary and Fiscal Interactions: Short-Run And Long-Run Implications’, Metroeconomica, 60, 1, pp. 197-223,
- Kapil, S. (2011). Financial management. Noida, India: Pearson.
- Krueger Alan. (2012). A Preview of the 2012 Economic Report of the President. Retrieved on February 22, 2014, from http://www.whitehouse.gov/blog/2012/02/17/preview-2012-economic-report-president
