Microeconomics of Financial Markets - Assignment Example

? Microeconomics of Financial Markets Task This paper discusses various topics in economics with the purpose of enabling a better understanding of the financial markets. It focuses on exchange rates, inflation, financial markets and monetary policies. Question One A rising dollar makes goods produced in the US expensive in other countries and while goods produced in other countries become cheaper for consumers in the United States. Thus, a rising dollar makes imports cheaper in the US and exports expensive in other countries (Mishkin, 2010). Foreign businesses that would like to purchase goods in the US have to convert the currencies they have into US dollars. However, a rising dollar makes the foreign businesses to use much of their currencies to obtain a unit of US dollar. Thus, the foreign businesses will use more US dollars to obtain a product in the US. This means that businesses in the US that export goods and services will prefer a rising dollar. As the dollar rises, they obtain higher amounts for the goods that they export. This would be the same for a European tourist who comes to the US to visit the Grand Canyon. The tourist will have to change the European pounds that he or she has for US dollars. However, in case the dollar is rising, it means that the value of the dollar is declining. Thus, one unit of European pound will fetch more units of US dollar (Thomas, 2006). Therefore, the European tourist will obtain more units of US dollars. He or she will be able to access more products and services when he or she reaches the United States. Question Two The Fed can use various methods to create money. Creation of money refers to the methods that the Fed uses to manage the quantity of money that is in circulation in the economy. One of the methods is through open market operations. This refers to purchase and sale of United States’ government bonds (Ritter, Silber, & Udell, 2004). The Fed can buy government bonds from the public. This increases the amount of money in circulation in the United States. As the government buys bonds, it releases money into the economy. Alternatively, in case the Fed wants to reduce the amount of money in the economy, it can sell government bonds to the public (Mishkin, 2010). The sale of government bonds makes the Fed take money from the public and offers the public bonds. Therefore, the amount of money in circulation decreases. The Fed can use commercial banks’ reserve requirements to influence the amount of money in circulation (Burton, Brown, & Burton, 2009). Commercial banks must retain a given proportion of the deposits they receive. Thus, commercial banks cannot lend all the money deposited in their accounts. An increase in reserve ratio means that commercial banks will reduce the amount of money that they lend to the public. This reduces the amount of money in circulation. On the other hand, a decrease in reserve ratio requirement means that commercial banks can lend more money to the customers. Thus, the amount of money in circulation increases. The Fed can also influence the amount of money in circulation through the discount window (Thomas, 2006). Commercial banks usually borrow money from the Fed since it is the lender of the last resort. The Fed usually charges an interest whenever commercial banks borrow money. The Fed can increase the interest rate it charges to the commercial banks to reduce the amount of money in circulation. Alternatively, it can reduce the interest rate to increase the amount of money in circulation. Finally, the Fed can make recommendations to the treasury so that money supply can be increased through printing (Ritter, Silber, & Udell, 2004). The Fed does not directly control money through printing or minting. The treasury prints notes and mints coins. This method can be used to direct the quantity of money in the economy. The most powerful method is the open market operation. However, the most commonly used method is the discount window or rate. It enables gradual reduction or increase in money in circulation. Question Three A stock option is a financial instrument (derivative) that states a contract that exists between two parties, and the transaction is to be accomplished at a future date at a given price (Burton & Brown, 2009). The buyer of the option has a right but is not compelled to buy or sell a stock at a certain agreed upon price. The value at which the stock is disposed is the stock option price. A call is an option that conveys to the buyer a right to acquire a stock at a given price. On the other hand, a stock option that conveys to the purchaser a right to dispose a stock at some given price is referred as a put. Finally, the company can set the price of its stock. The price that the company decides to set for the stock is termed the strike price. Stock options have various advantages and disadvantages over stock. Stock options provide holders with leverage, i.e. the possibility of gaining control of a vast asset through the use of a small amount of money (Ritter, Silber, & Udell, 2004). Additionally, stock options enable the trader to generate income using credit spreads. The trader can take advantage of stocks that have trading ranges by creating bull put spread. Additionally, they are cheap, i.e. there is a low capital requirement. Finally, the other advantage of stock options is that the only loss an individual can make is the actual premium paid for the options. Even though the option allows one to control an enormous asset, the only loss one can make is the actual capital. The advantages discussed are not possible with stocks. The disadvantages of stock options are that they offer low liquidity (Burton & Brown, 2009). It is difficult to convert the options into cash. The gains made from stock options are also taxed. Thus, they are almost similar to ordinary income. The tax rate can also be high. Apart from taxes, stock options pay commission rates for every dollar invested. The commission rates are usually high. Additionally, many traders are not able to understand how stock options operate. Finally, traders who have invested in stock options are usually uncertain about the productivity of the investment (Ritter, Silber, & Udell, 2004). Mutual funds allow investors in the financial markets to take the benefit of diversified ranges without using a large amount of money in investment. They are a wide stock holding that an expert manages on behalf of investors. Question Four Discount rate refers to the rate at which the Fed charges commercial banks when the commercial banks borrow money. The Fed acts as the loaner of last resort and thus charges interest on money borrowed by commercial banks (Mishkin, 2010). In acting as the lender of last resort, the Fed acts as a bank for the commercial banks. On the other hand, prime rate is the rate that commercial banks charge on their clients that are most creditworthy. Usually, the most creditworthy customers of commercial banks are large corporate organizations. These kinds of clients have the ability to service large loans. Therefore, the commercial banks have confidence in them. Finally, subprime rates are the interest rates that commercial banks charge on poor individuals when they borrow loans. Banks usually offer subprime loan rate to people who do not qualify for prime rate loans. It is possible that lending of subprime loans could have caused the financial crisis in 2008. Many institutions offered loans, especially mortgages, at subprime rates. Most of the loans at subprime rates were offered to risky groups: African Americans and Hispanics. Additionally, some of the loans were nonperforming. Nonperforming loans are those in which the loaned individuals do not remit repayments for loans that they have obtained from the credit institutions (Burton & Brown, 2009). Question Five Inflation refers to persistent and continuous rise in the prices of goods and services in the economy (Thomas, 2006). Inflation targeting is the method in which the monetary authority determines the inflation rate that it hopes to achieve in the year. The monetary authority then announces the targeted rate of inflation. The monetary authority then controls economic activities in the economy by attempting to maintain the targeted level of the inflation rate. It directs monetary policies towards achievement of the targeted rate of interest. If the inflation rate rises past the targeted level, the monetary authority implements monetary policies that result in an increase in interest rates. This assists in reducing the amount of money in circulation. On the other hand, if the inflation rate falls below the targeted level, the monetary authority will implement monetary policies that result in a reduction of interest rates. This assists in raising the amount of money in circulation since many people will be able to take loans from the commercial banks (Burton & Brown, 2009). If the targeted rate is 2% and inflation goes past 2%, the monetary authority increases the rate of interest. If it goes below 2%, then the monetary authority reduces interest rates. This is different from interest rate targeting. Interest rate targeting involves determination of an appropriate level of interest rate without laying focus on inflation. Ben Bernanke prefers inflation targeting. Additionally, many countries use inflation rate targeting. Some of the countries that use inflation rate targeting include Britain, South Korea, Sweden, Canada, New Zealand, Australia and Brazil among others (Ritter, Silber, & Udell, 2004). Question Six Banking began in the middle ages in Europe. Individuals held disposable wealth in the form of gold and silver during this period. The local goldsmiths provided a safe in which people could keep their gold and silver. The goldsmith issued receipts for deposits made by individuals (Thomas, 2006). People went and withdrew their deposits whenever they had financial transactions. Thus, a person could come, withdraw gold and give it to the seller. The seller would then deposit it again at the goldsmith’s premises. This consumed a lot of time. Hence, individuals began to offer the goldsmith’s receipts as payment. After some time, the goldsmiths began to offer receipts for a specific amount of gold and silver. Therefore, the receipts given out by the goldsmiths became the first form of bank notes. The goldsmiths realized that at certain times, the deposited gold was not being withdrawn. Therefore, they issued more receipts in the form of loans. Additionally, they used some of gold to make more money. This formed the basis of fractional reserve lending. The loans that they issued had to be paid back with interest. Thus, the non-existent money they lent began to materialize. The beginning of the industrial era further promoted the practice of the goldsmiths. The goldsmiths transformed into bankers and managed to control large industries. Mostly, families owned the banks (Ritter, Silber, & Udell, 2004). These elite family banks had a strong influence on monarchies and governments. In the twentieth century, the banks realized they could control the world through restriction of money supply. Through these financial crashes, wealth is usually transferred and not destroyed. Lately, the banks have incorporated technological advancements such as mobile, Internet and computer technology to develop further. Through technological advancements, banks have enabled increased rate of money transfer that lacked during the goldsmiths’ period. Question Seven The Fed chairperson in the 1970s, Mr. Paul Volcker, managed to reduce the double-digit inflation rate by restricting money supply (Burton & Brown, 2009). Originally, the Fed practiced interest rate targeting. However, the inflation rate increased considerably. Thus, the Fed, under the leadership of Volker, decided to restrict the money supply. The interest rate policies that he formulated ensured that the amount of money in circulation reduced. This resulted in increased interest rates. Individuals could not borrow money from the banks due to the increased interest rates. This assisted in reduction of money in circulation. Hence, the inflation rate reduced. The method that Volcker used was a monetarist approach (Burton & Brown, 2009). This approach is mainly associated with Milton Friedman. Question Eight Interest rates and bonds have a negative relationship (Mishkin, 2010). When the interest rates go up, the prices of bonds go down. Additionally, when the interest rates go down, the prices of bonds go down. This inverse relationship can be explained through the concept of opportunity cost. Investors in bonds usually make a comparison of the returns that they expect on their current ventures to what they are likely to get in other markets. With changes in interest rates in the market, bond coupon rates change. Thus, the bonds become more or less suitable or attractive to investors. Therefore, investors will be willing to give more or less for the bonds in the market. There is a difference between treasury bills and corporate bonds. Treasury bills (T-Bills) are promissory notes that the Treasury Department of the United States issues to the public for a maturity tenor of not more than a year. They are an investment that has relatively low credit risk (Thomas, 2006). Treasury bills are debt-financing instruments that the treasury uses. On the other hand, organizations or corporations issue corporate bonds. Corporate bonds are debt securities sold to investors. Additionally, they are issued to assist the corporation in raising money. Moreover, corporate bonds mature after one year after the issue date. Unlike treasury bills, corporate bonds are high-risk investments. Due to this, many people usually prefer to invest in treasury bills whenever stock market fails. Treasury bills offer investors a higher security for their investments than corporate bonds. Question Nine The Fed can use bond market to create or destroy money in the country. The Fed can achieve this using open market operation (OMO) (Burton & Brown, 2009). If the Fed wants to create money, it can decide to buy bonds from the public (Thomas, 2006). Thus, it will release the money into the economy; it creates money as the public gives it bonds. On the other hand, if the Fed aims to destroy money, it reduces the money supply and can sell bonds to the public. Through the sale of bonds to the public, the Fed collects money from the public. This has the effect of decreasing the amount of money in circulation. Many developed countries usually practice inflation targeting to reduce the chances of experiencing inflation targeting. In this method, monetary authorities of these developed countries decide on the level of inflation to be maintained (Thomas, 2006). After determination of the appropriate inflation level to be targeted in the year, the monetary authority formulates monetary policies that ensure the right level is achieved. Therefore, if inflation goes past the targeted level, the monetary authority implements monetary policies that increase the interest rates. On the other hand, if inflation goes below the targeted level, the monetary authority implements monetary policies that ensure that interest rates decrease. However, unstable countries do not use this method. Unstable countries usually use interest rates targeting to influence lending in the country. This is mainly because they do not have the capacity to carry out inflation targeting. The aim of this paper was to enhance the understanding of financial markets. It managed to achieve the goal through discussion on various topics. The main topics discussed in the paper include exchange rates, control of inflation, financial markets and banking. References Burton, M., & Brown, B. (2009). The financial system and the economy: Principles of money and banking. Armonk, N.Y: M.E. Sharpe. Mishkin, F. S. (2010). The economics of money, banking, and financial markets. Upper Saddle River, NJ: Pearson Prentice Hall. Ritter, L. S., Silber, W. L., & Udell, G. F. (2004). Principles of money, banking, and financial markets. Boston, Mass.: Pearson Education. Thomas, L. B. (2006). Money, banking, and financial markets. Mason, OH: South-Western. Read More