Analysis of Unemployment and Inflation - Essay Example

Economic Concepts Yield to Maturity The yield to Maturity of a bond is the interest rate that makes the present value of the cash flow receivable from owning the bond equal to the price of bond. Mathematically, it is the interest rate ( r ) that satisfies the following equation: C C C M P= ------ + ------ + ...........+ -------+ ------ (1+ r) (1+ r)2 (1+ r)n (1+ r)n Where P = price of the bond C = annual interest (in Dollars) M = maturity value (in Dollars) n = number of years left to maturity The interest payment on bond is called coupon payment and accordingly interest rate on bond is coupon interest rate. The only general procedure for calculating the yield to maturity is trial and error, but spreadsheet programmed or electronic calculators are also used for sake of convenience. But Yield to Maturity is not always the most accurate measure of rate of return on bond sold prior to its maturity. It is not only sometime deceptive but also can also be misleading. Reasons are as under: a) When the current price of bond is equal to its par value, yield to maturity will always be equal to coupon interest rate. But when bond value differs from par, the yield to maturity will differ from the coupon interest rate, and this causes some inaccuracies in measuring the rate of return on bonds sold prior to maturity. b) Though the procedure used to calculate YTM in case of bonds paying interest semiannually is same as in case of bonds paying interest annually, but finding out the price or present value of bond paying semi annual interest involves Converting annual interest(C ) to semi annual interest by diving annual interest by 2. Converting the year of maturity ( n ) to the number of sic months period to maturity by multiplying n by 2 On calculating YTM by using the above parameters it will be seen that the bond’s price or present value is lower when semi annual interest is paid. This will happen when bonds are selling at discount. But when bonds will be selling at premium, the price or present value will be higher in case of semi annual interest bonds in comparison to annual interest paying bonds. c) When YTM is calculated, the same rate is used to discount all payments on bonds. But when cash flows on bonds occur at different intervals, interest flowing in annually or semi annually and principal amount with last period interest at maturity, then cash flows are bound to be not identical. Un- identical cash flows on same bonds are bound to get different YTM. That is why when bonds are sold before maturity its cash flows will not be identical with bond that is not sold till maturity. Therefore yield to maturity is bound to be different than reflected by its coupon rate. It can rarely be accurate and that too by chance. Accordingly it is said that YTM can be misleading when bonds are sold prior to maturity. 2. Effect of increase in demand for borrowing money on loanable funds market. Loanable funds in an economy refers to all saving of income that people have decided to lend out instead of using that for consumption purposes. Financial market in an economy functions like any other market controlled by demand and supply forces. Supply of funds for loanable fund market comes from those who save their income and offer those savings for lending purposes. Demand for loanable funds is also called borrowings. This demand for loanable funds, or the borrowing money from loanable fund market, is generated by those needs of funds of the people and firms for investment purposes. Demand for loans comes from all type of borrowers, namely consumer borrowers, commercial or business borrowers and even from governments (say when governments float treasury bonds). Increase in total demand for loanable funds is the cumulative result of increase in demand from all these quarters, and its effect on loanable fund market will be as under: a) Whenever consumers are short of money and require funds, they do not immediately resort to borrowings. Consumers sell their investments, like bond holdings and others, in order to replenish their money holdings. With the result prices of investments fall and consequently interest rate will rise, as the buyers of investments need money to pay consumers. As the interest rates rise consumers will start economizing on cash holdings and this will further raise the interest rate so high that people will not be able to find buyers of their investments. Naturally demand for loanable funds and interest rate thereon will come down to equilibrium level in the ultimate analysis. b) Business community creates demand from loanable fund market for the purposes of investments into different ventures. The business community ranks investment opportunities based from highest to lowest depending upon expected marginal rate of returns on such investments. The demand of loanable fund for business community will increase until marginal rate of return on such investment equals the rate of interest on loanable fund. The effect is that demand of money from commercial sector will lower the rate of interest till it equals marginal rate of return on investments, because business community will not borrow when interest rates are higher than marginal rate of return on investments. 3. Trade off between risk and return for bonds The basic ingredients to be considered in choice of an investment are its risks and returns. Trading off risk and return implies high returns for high risks on investments and vice versa. One can say trading off is a process where risks are offset by the corresponding returns from investments. Risk in investments is reflected in the marginal costs of investments; whereas rewards or returns of investments are the opportunistic benefit or marginal benefit of such investments. Investors have to choose between higher risk- high returns or low risk- low return investment. This risk and return trading off decision is very crucial. For example the investment in bonds of a new corporation may be risky but it may offer suitable return. At the same time Treasury bill investment may be comparative less risky but returns there from are also low. Investor has to evaluate each investment separately to arrive at an optimum decision. In reaching this trade off decision use of ‘beta’ technique helps in selecting nearly suitable and appropriate investment alternative. There are two types of risks involved in an investment, namely systematic risks and unsystematic risks. Systematic risks arise from uncontrollable situations like inflation, interest rate changes. Unsystematic risks are the result of company’s own problems like financial difficulties of the company. Expected results on an investment are related to beta as: Expected returns = Risk free Rate + Beta * Market Risk Premium Where Market Risk Premium = Market Return Risk- Free Rate. Beta= security’s volatility compared to an average security. When beta is zero, the security is risk free, and with increasing beta risk on security gets increased. We can also put it this way that higher the beta, the higher is risk and return on investment and vice versa. The three investments under consideration have been classified as under on basis of regular beta information available from markets: Total Interest Rate Business Rate Market Risk Return Risk Risk Treasury Bonds Low High Very Low None City Issued M.Bonds Average Average Low Average Corporate Bonds High High High High Based on above method, the investment strategy of a retiree can be planned by trading off risk and returns. As the retiree needs fixed income with less of risks involved, the best option is to go in for major chunk of retiree’s funds invested into Treasury Bonds. However some marginal portion of available funds can be invested into Municipal Bonds to take advantage of average risks involved in that. But high risk high return corporate bonds are not at all recommended for retiree. 4. Keynesian theory vs. Expansionary monetary policy The basic purpose of a ‘Monetary policy’ is to control total demand in the economy by influencing the amount of money and loan fund available and thereby the interest rates in the economy. Expansionary monetary policy is such a monetary policy of the central bank of a country whereby the money supply is expanded in the economy. The central bank accomplishes this expansion in a number of ways and for a variety of purposes. Money supply in the economy can be expanded by say lowering the interest or discounting rate, by purchasing treasury bonds or other government loan securities earlier floated by government in to the economy, or by reducing reserve requirements of banks and other financial institutions. The ides is to expand money supply for the purpose maintaining or increasing the economy’s GDP. One can say that expansionary monetary policy of the central bank provides a boost to the economy through increase in rate of growth of money supply. That is why expansionary monetary policy is also called growth model. But as the money market is non- dynamic or non- static in nature, it is not that easy to inject the money supply , but once the money supply is expanded into the money market, its results can be predicted easily because of this very static nature of money market. One important requirement for maintaining the growth of an economy is the environment of comparative price stability and absence of inflationary reactions. Here the expansionary monetary policy of central bank plays a role of mobilizing resources to boost the GDP. Such practice of expanding money has become so regular in this modern economic set up that this expansionary monetary policy has come to be known as modern monetary theory. On the other hand Keynesian theory regards money as stock, whereas expansionary monetary policy treats money as a flow. That is why the rate of interest as per Keynesian theory explains the rate of interest at any given time when the money stock is assumed to be fixed. The quantity of money as per Keynesian theory is an independent variable and is not affected by the rate of interest. But expansionary theory believes that stock of money is dependent on interest rates. That is why central bank expands money in economy by reducing interest rates. According to the Keynesian policy it is the demand for and supply of money that determines the interest rate and thus the monetary policy is demand and supply created by the economic processes of the system. But expansionary theory treats the rate of interest simply as the price of credit and, as such, determined by demand for and supply of loanable funds. That is why banking system can influence the rate of interest by expanding or contracting money. 5. Multiplier effect on repayments of loan taken from bank The transaction of loan repayment by Bob to the banks is not at all dependent upon Bob’s deposit with the bank. When Bob will remit a portion of the principal amount on loan taken from bank, the bank cash balance will be increased by that amount and the principal amount will get reduced. With this additional cash in hand with the bank, the bank is in a position to grant further loans to its constituents keeping the necessary reserve balance as required by the law. In effect the bank will generate more money into the market by further advancing the loans out of the remittances from original distributed loans. This process of generated income and money is repeated again and again whenever the cash balance of the bank is enhanced by such remittances of repayment of loans. This regeneration of money into the market by the bank is called the Keynes’ Income or investment multiplier. This multiplier effect of money suggests that a given increase in investment ultimately creates total income or money which is many times the initial increase in income resulting from the investment. That is why it is called income or investment multiplier. With the help of marginal propensity to consume, we can express in a systematic manner the relationship between a given increment in investment and resulting change in income. Suppose $1000 investment takes place, then in the first impact income $1000 would be created for persons engaged in investment activities. The recipients of income will spend part of it and save the rest- the magnitude will depend on their marginal propensity to consume (MPC). Suppose MPC is ¾, then recipients will consume $750. Now recipients of income of $750 will again consume ¾ of that $ 750, i.e.$562.50, and the process goes on and on. Thus one primary round of expenditure creates income or money much higher than original $ 1000 and this can be expressed as Δ Y= ΔI * k, Where ΔY is increase in income, ΔI is increase in investment, and k is the multiplier. Following this equation in the first stage $1000 investment will give rise to $ 4000 increase in the national income, and therefore the multiplier (k) is 4. This exactly will happen on Bank’s balance sheet when Bob will return the principal amount of loan taken from bank. 6. Investment strategies of insurance companies While selecting securities under a portfolio of investment for insurance companies under noted points need careful consideration: Insurance companies are required to maintain a minimum net worth of investments and other assets as required by the respective laws of the nation. Insurance companies are supposed to hold sufficient assets of appropriate nature, term, and liquidity that ensures that company would be able to meet its liabilities as those liabilities become due. Assets pertaining to long term business and general business need segregation. These segregated funds of one section are not chargeable as securities against liabilities from other section of the business. Selection of securities must adhere to strategic investment policy of the insurance company, that also provide a system for identification, assessment, and measurement of investment risks involved.. Procedure for changes in investment portfolio should be as per laid down approved policy of the company. Though general rules prescribing limits and prohibitions of investment would be as per the law of land, but the management must select securities for investments that do not contravene under noted general rules available in most of statues of different countries: a) Not more than 20% of the actually determined reserves need to be invested in equities. b) The investment portfolio of securities should be as per risk profile and the liquidity requirements of the insurance company. c) Investment in derivative securities has to be strictly approved by Insurance Authority of the nation. d) Portfolio managers, selection of brokers, custodial arrangements, and methodology of performance assessment has to strictly as approved by the board of the insurance company after getting approved by the local and federal governments 7. Effect under classical theory of more savings than the required investments Under classical theory rate of interest is determined by the equilibrium of savings and investments. Classical theory is also known as real theory of interest According to this theory the rate of interest is a payment of savings. Therefore the rate of interest is determined by demand for savings in capital goods and supply of savings. Under perfect competition, it is profitable for a firm to purchase any factor of production only up to the stage where the price of that factor equals its marginal revenue productivity. Rate of interest is the price of saving. An entrepreneur will demand capital goods or for that matter savings up to the point at which expected net rate of return on capital goods equates the rate of interest. According to this classical theory the money to be used to purchase capital goods is supplied by those who save the money from their current income. People save money by postponing their demands for consumption. More saving the people will do the more consumption they have to postpone for future period. To persuade them to do so the rate of interest must be higher to justify such postponement. As stated earlier the rate of interest is the result of inter action of forces of demand and supply of money. Under perfect competition rate of interest is equal to net rate of return on capital goods. When there will be more savings of money than required as per rate of return on capital goods, or where the interest rate equates such rate of return on capital, excess supply of money than its demand will lower the interest rate, and this will happen because of the following reasons: a) More savings means more money available for investments. b) Postponing the consumption to a future date will lower the demand for capital goods; and therefore investments will be adversely affected. c) With the result equilibrium rate of interest will be lowered as per the excess supply of money. 8. Economy in equilibrium as per classical theory under less than full employment Full employment refers to a state of the economy where all productive resources, namely, land, labor, capital and enterprise, are fully employed. In other words none of productive sources are lying idle or under- employed, and that situation is technically called ‘economy in equilibrium’. But according to classical economist full employment is a situation under equilibrium economy where there is no involuntary unemployment, though there may be voluntary, casual, seasonal, structural unemployment. In other words technically there may be less than full employment because of voluntary, casual, seasonal, or structural unemployment even under situations when economy is said to be in equilibrium. That is why classical economists treated full employment under ‘economy in equilibrium’ a situation where every one who intends to work at ruling rate of wages is treated as employed. They believed that at any given time full employment in its literary sense is unattainable because there is bound to be some seasonal and frictional unemployment. Keynes and many after him defined full employment level as a level in an economy which falls short of full employment in its literary sense. Even the Economic and Social council of U.N. has accepted this definition of little less than full employment when as per classical economists economy is said to be in equilibrium The purpose of such a standard is to provide “full employment which is consistent with small amount of unemployment that a country can reasonably be expected to have, after a minimum allowance is made for seasonal and frictional unemployment” 1 Even Keynesian full employment is the maximum level of employment that private enterprise country can attain without experiencing strong inflationary pressures. Accordingly classical economists treated the economy in equilibrium even when there was employment a little lower than full employment because of seasonal, structural, and frictional unemployment. They in fact reduced the concept of full employment in quantitative terms, as remedial measures can be adopted to achieve the full employment level. In a way such a situation is auto corrective situation where corrections occur automatically in the economy to reach full employment level. 9. Velocity of Money Velocity of money or velocity of circulation of money means average number of times a particular unit of money to change hands, in order to obtain all the sales and purchases transactions that are necessary to produce a particular level of say national income in an economy. In other words velocity of money is determined by a cause to be achieved, e.g, in order to achieve a particular level of national income. The important point to note in ‘velocity of money’ is that it does not happen on its own. There has to be some motivation or causing effect to raise velocity of money. Like a particular level of national income may the cause of raising the velocity of money. In order to understand the role of velocity of circulation of money let use understand the quantity theory of money. As per quantity theory of money MV = PY, where M stands fro money stock, V for velocity of circulation, P for over all price level, and Y for level of output of production. Under such equation Inflation rate, i.e., price growth may be assumed as under: Inflation (%) = Money Growth (%) + Velocity Growth (%) – Output growth (%). The important thing to note is that velocity of money does not have an independent role in effecting inflation. There has to be money growth first, and velocity of money only rotates that growth for a cause to be achieved and in turn may add to inflation in an economy. Basically growth of money is the cause of rise in interest rates in a static economy.; and that represent the level of inflation. The role of velocity is positive but secondary in raising the level of inflation. For example with increase in opportunity cost of holding money, real demand of money gets reduced but velocity of circulation rises. For inflation to be directly effected by velocity, the existence of positive strong relations between average growth rate in money creation and average money velocity is very important. Thus velocity has a role in creation of inflation but it is not a primary role. Primary role is played by growth in money creation. We can changes in velocity in money adds fuels to fire to create more inflation only when there is primary growth in money creation, and vise versa is true for deflationary situation. Money and its velocity during hyperinflation: In a way hyperinflationary situation in an economy is an out of control situation. There is unchecked increase in money supply or money growth. Velocity in money further worsens the situation. It is a sort of inflationary cycle without any direction to achieve any sort of equilibrium. A free for all situation. One effect of a cause becomes the cause of other effect. Money growth become routine and velocity for the cause of worsening the situation adds fuel to fire. 10. Right amount of money in an economic system Right amount of money in an economic system is a situation that can exist only when money remains neutral. Neutrality of money implies that creation of money may generate prosperity, but will not affect output and employment in any manner. It is true that change in quantity of money may generate economic fluctuations, but its neutral effect will only generate prosperity. The right quantity of money will not alter the real equilibrium of the economic system. That is to say, when quantity of money is just right, the relative prices and interest will not get affected by a change in the quantity of money. Such a neutral effect of money can take place only under the following circumstances: a) There exists only one kind of money, i.e., either inside money (created against private debt and constituted by claims against financial institutions) or outside money (backed by foreign and government securities) b) Complete absence of illusion of money. c) Price – wage flexibilities do not exist. d) There are no open market operations, and finally e) There is unitary elasticity of expectations. Such a situation is hypothetical and thus measuring right amount of money for an economy can only be a theoretical exercise. References 1 U.N., Problems of Unemployment and Inflation, 1950 and 1951, page 5 Read More