Financial Management III Scenario

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Course Learning Outcomes for Unit III Upon completion of this unit, students should be able to:

1. Explain foundational finance theories. 1.1 Explore the concepts of crediting rates, inflation rates, and types of debt as related to a

business scenario.

2. Analyze a financial forecast using relevant data. 2.1 Define the relationship between yield curves and the structure of interest rates.

5. Prepare preliminary financial statements and ratio analyses.

5.1 Discuss the ratios necessary for the assessment of the financial health of a business.

Course/Unit Learning Outcomes

Learning Activity

1.1

Unit Lesson Chapter 7 Chapter 8 Unit III Case Study

2.1 Unit Lesson Chapter 8 Unit III Case Study

5.1 Unit Lesson Chapter 8 Unit III Case Study

Required Unit Resources Chapter 7: Savings and Investment Process Chapter 8: Interest Rates Unit Lesson During this unit, we will examine the savings and investment process and interest rates. We will examine the major components of the gross domestic product (GDP), we will explore the factors that impact savings, and we will look at the main sources of savings. Further, we will evaluate the types of capital market securities that assist the savings and investment process. Finally, we will briefly touch on mortgage loans and how the mortgage markets enable home ownership.

GDP, Capital Formation, and Sources of Savings In theory, the monetary policy adopted by the Federal Reserve has an effect on the rate of GDP growth. An expansive monetary policy characterized by low interest rates during periods of recession is intended to stimulate economic activity and growth. A restrictive monetary policy characterized by higher interest rates is intended to reduce economic activity and control inflation. Research examining the effect of monetary policy on GDP, however, has determined that the effect on GDP is more significant during periods of expansion and

UNIT III STUDY GUIDE Monetary Systems and Interest Rates

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inflation than during recession (Tenreyro & Thwaites, 2016). In effect, monetary policy alone may not be a sufficient stimulus to raise GDP during a recession. GDP is composed of four elements: personal consumption expenditures, government expenditures that include investment, private domestic investment, and net exports of goods and services. Gross private domestic investment is the source of capital to support business activity on which the economy depends (Melicher & Norton, 2020). A link exists between savings and investment with the amount of available savings determining the amount of investment. Savings requires excess funding that is not necessary for immediate consumption and is therefore set aside for future consumption or investment. Investment involves the purchase of assets that can be used to generate future production. Private savings is a major source of savings for capital formation. Undistributed corporate profit is generally the largest source of savings in the U.S. with corporations holding the profits for later use. The undistributed corporate profit is adjusted by inventory valuations with an investment in inventory not considered undistributed profits (Chen et al., 2017). Personal savings are the next largest source of savings. Government sources of savings are collected revenues that are not spent. The amount of federal deficit is so high that the net savings for the United States is generally negative. From the early 1970s through the end of the 1990s, the U.S. government functioned with an annual budget deficit. While the surplus budgets of the next four years were realized due to more efficient budgeting and forecasting, the deficit quickly started growing in 2002. For instance, during the fiscal years 2009–2012, the budget deficits surpassed $1 trillion annually (Amadeo, 2020). The U.S. National Debt Clock shows the actual debt figures in a real-time mode. The site not only illustrates the debt figures, but it also highlights tax revenues, unemployment figures, and both state and world debt totals.

Supply and Demand for Loanable Funds The Federal Reserve uses interest rates as the means to control the rate of growth of the money supply in the United States (Palley, 2015). In theory, interest rates help protect the economy from recession by accelerating the growth of the money supply with lower interest rates and protect the economy from inflation by decelerating the growth of the money supply with higher interest rates. The Federal Reserve has various other tools to implement monetary policy. The Federal Reserve can raise or lower the discount rate, which is the amount charged to member banks to borrow from the Federal Reserve to maintain the amount of required reserve. The Federal Reserve can also change the reserve requirements for banks, which can influence the amount of funds the bank can use to make loans to customers. Another method the Federal Reserve uses to manage interest rates is the purchase and sale of treasury debt; the sale reduces the amount of money in circulation to increase interest rates while the purchase increases the amount of money in circulation. Interest rates influence the supply and demand for loanable funds with supply and demand in equilibrium at the current interest rate. If the interest rate increases, the demand for loanable funds will decrease because the loan becomes more expensive at the higher interest rate. In effect, the demand curve shifts to the right. At the same time, the supply of loanable funds will increase because lenders can obtain a higher return, shifting the supply curve to the left. A new equilibrium is established with more supply but less demand (Arnold, 2010).

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Capital Market Securities There are two types of financial markets that can be utilized for investing: money markets and capital markets. The difference is based on the time frame of the markets. For instance, money markets issue and trade debt securities of one year or less. Alternatively, capital markets issue and trade debt securities with a maturity longer than a year. See below for a table that breaks down the type of security and a short explanation of each (Anspach, 2020). These securities could also be evaluated based on level of risk; in this case, the treasury bonds would be the least risky based on their stable terms.

Security Description Mortgage Backed by real property in the form of buildings

and houses. Typical maturities are 5 to 30 years.

Treasury note/bond Debt instrument issued by the U.S. federal government. Typical maturities are 2 to 30 years.

Municipal bond Debt instrument issued by a state or local government. Typical maturities are 2 to 40 years.

Corporate bond Debt instrument issued by a corporation to raise long-term funds. Typical maturities are 2 to 30 years.

Common stock Security that indicates ownership interest in a corporation. There are no maturities on common stocks.

Market Interest Rates

Market interest rates differ from nominal interest rates because of the compensation that a lender requires reflecting the opportunity costs and the risks associated with a loan. By making a loan for a fixed period, the lender forgoes other opportunities that may arise with a premium above nominal interest rates compensating the lender (Melicher & Norton, 2020). Inflation is a component of the market interest rate because of the likelihood that the value of the principal will erode over time because of inflation. Default risk is also a component of the market interest rate with the premium varying based on the creditworthiness of the borrower. Maturity risk can increase the interest rate for longer-term loans because of the difficulty of forecasting long-term events such as future interest rates. Liquidity risk is an additional premium added to loans that cannot be easily converted into cash in a secondary market.

Inflation Premiums and Price Movements The inflation premium reflects the amount of anticipated inflation over the life of the loan. The inflation premium is intended to compensate the lender for the loss of purchasing power from inflation. In effect, the lender bears the risk that actual inflation will be higher than anticipated at the time the loan is made while the borrower bears the risk that the inflation will be lower than anticipated at the time the loan is made. Inflation can have a significant effect on price movements because interest rates in periods of very high inflation can be substantial. As the inflation increases, the market value of existing loans decreases because of the higher inflation premiums lenders demand to compensate for inflation.

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At times, the price level can increase without any change in the overall money supply if costs outpace productivity. Individuals will feel the impact first-hand in the form of higher prices. Known as cost-push inflation, the costs, not the money supply, is the cause of the increased prices. These types of inflation are not mutually exclusive and are present at the same time. Another type of inflation, speculative inflation, occurs as a result of an increased money supply. If prices have been rising for a while, then it is assumed they will continue to increase. Instead of these higher prices creating a decrease in demand, the opposite occurs. Thus, instead of product demand decreasing due to higher prices, we see an increase in demand as consumers fear for the worst and would prefer to stock up on the goods. As consumers, it is important to be able to distinguish between the hype and the necessity and/or utility of the good/service.

During the 1950s through the 1970s, high levels of inflation persisted. Many people considered this phenomenon to be a long-run inflationary bias. Wages tend to increase during periods of rapid growth and economic expansion. The U.S. government is tasked with reducing unemployment, which not only strengthens the economy but enables the wages to stabilize more consistently over time. In summary, we examined the basic functions of GDP and how it serves as a forecasting tool for future action. We evaluated the impact of interest rates on markets and funds/savings. Further, we touched on inflation and price movements and how they interact with changes in the markets. Finally, we wrapped up the lesson by assessing the role of government on inflation.

References

Amadeo, K. (2020, April 21). Current U.S. federal budget deficit. The Balance. https://www.thebalance.com/current-u-s-federal-budget-deficit-3305783

Anspach, D. (2020, June 27). Three types of securities investments. The Balance.

https://www.thebalance.com/what-are-securities-2388638

Arnold, R. (2010). Macroeconomics. South-Western Cengage. Chen, P., Karabarbounis, L., & Neiman, B. (2017). The global rise of corporate saving. Journal of Monetary

Economics, 89, 1–19. Melicher, R. W., & Norton, E. A. (2020). Introduction to finance: Markets, investments, and financial

management (17th ed.). Wiley. https://bookshelf.vitalsource.com/#/books/9781119560579 Palley, T. I. (2015). Money, fiscal policy, and interest rates: A critique of modern monetary theory. Review of

Political Economy, 27(1), 1–23. Tenreyro, S., & Thwaites, G. (2016). Pushing on a string: U.S. monetary policy is less powerful in recessions.

American Economic Journal: Macroeconomics, 8(4), 43–74.

Tolibov, G. (2018). ID 110219625 [Image]. Dreamstime. https://www.dreamstime.com/inflation-chart- blackboard-growth-inflation-chart-word-inflation-board-image110219625

Inflation greatly impacts financial management. (Tolibov, 2018)

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Learning Activities (Nongraded) Nongraded Learning Activities are provided to aid students in their course of study. You do not have to submit them. If you have questions, contact your instructor for further guidance and information. How well do you know the unit material? Take the Unit III Knowledge Check Quiz to find out! (PDF of Unit III Knowledge Check Quiz)