Questions on Implementation of Monetary Policies, Demand and Supply - Paper Example

With regards to the economic theory, among the tools that are used in the implementation of monetary policies, capital reserve ratio is one of them. The capital reserve ratio is the amount of money (from the deposits of the customers) which banks must maintain in the reserve. The money cannot be lent to customers. Banks have two main sources of funds; capital and money that they borrow. However, over reliance on debts have its own disadvantages. First, it is impossible to postpone payment of debts. Because many of the liabilities of a bank have to be paid on demand, failure to meet these withdrawals can lead to the closure or collapse of the bank. As such, it becomes imperative for banks to hold capital. The capital ensures that there is no shortfall in the cash flow as it is possible to suspend dividends and the effects will not be adverse. Secondly, in case of bank closure, debts will be paid through the capital. Holding capital minimizes the risks undertaken by the bank. This is because these risky undertakings put the capital at risk in case they are not successful. Compared to investors, banks are more aware of the details of the projects and operations that they undertake (information asymmetry), as such, deciding to hold more capital and make depositors and investors incur great losses if the banks fails is a risk that the bank cannot undertake.

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Banks lend money to customers who pay it back with interest. This interest is one of the sources of funds for banks. However, the lenders may default in paying back the loans. This gives rise to the concept of credit default risk. This can be defined as the risk on defaulting on repaying a loan. In case of default, the lender (bank) stands to lose the principal and the interest. In addition to that, there will be disruption to the banks cash flows while the collection costs are going to increase significantly. The loss incurred by the bank can either be whole or partly. When the market is associated with efficiency, there will be greater levels of credit risk and this will translate to higher costs of borrowing. This is the reason why there are measures and techniques which are used in inferring the levels of credit default risk. Yield spreads is one such tool. The only way to ensure there are no defaulters is through not giving loans. However, this will mean that banks will not make any profits and yet they are driven by profit making motives. This creates a trade-off between default risk and profitability. To minimize credit default risk, there are a number of measures which the bank undertakes. The first one is carrying out a credit check on the person seeking funds. This will help in establishing whether the borrower has a history of defaulting and if thats the case, the bank will not loan out to him. Secondly, the bank may ask the borrower to take insurance over the loan. In case the borrower defaults, the insurer will be responsible. The bank may also decide to ask for some assets belonging to the borrower, these will act as security. Fourth, the bank may seek a guarantee from a third party, which endorses the borrower and pledges to pay back the loan in case of default.

TASK 3-MONEY MARKETS

Illustrate daily yield for bill across the week (table or bar graph)

Provide an explanation for the change in yield across the week. Use the equation for valuing treasury bills as the basis for the explanation (400 words)

Treasury bills can be described as short-term debt securities. Their period of maturity could be even a year. Treasury bills are issued by the central bank or the government. Their main purpose is to cover the states budget deficits which are short term in nature. The central bank uses treasury bills to control liquidity among banks. Treasury bills are vital fiscal policy tools for the state and an important monetary policy tool for the central bank.

Valuing of bills is dependent on whether the bill price is based on the rate of discount or on the rate of return. Of the two, the return is usually greater than the discount rate. For treasury bills maturing after a period of three or six months, the discount yield equation used is:

Discount yield = [(FV - PP)/FV] [360/M]

FV represents the face value

PP represents the purchasing price

M represents the maturity period of the bill

360 represents the total no of days that the bank uses in the calculation of short-term interest rates (When using the investment yield method, the number of days is taken to be 365 or 366 instead of 360).

The changes in the yields within the week could be attributed to the changes in the rates of interest and the changes in credit quality. Market risk can be defined as the fluctuating behavior of bonds with regards to their prices due to changes in the rates of interest. Other factors that may have contributed to the changes include; fluctuating economic conditions, for example, treasury bills rise during when the business records high profits and they fall when profits reduce. The profit made daily cannot be constant, it keeps fluctuating and as such, this played a role in influencing the yield changes. Inflation and inflation expectations could have caused the yield changes as well. High inflation rates means that the rates of interests will be high on the treasury bills. Other factors which affect yield changes in the long-run include monetary policies, the demand and supply of risk-free fixed income securities and the number of treasury bulls supplied by the government.

Demand and supply analysis required with full market process (200 words)

The demand function of bonds

When the price of a bond reduces, investors are going to buy more demands. Therefore, the demand function has a negative slope. There are several factors which increase the demand for bonds. When the economy is growing, a lot of wealth is generated. Therefore, people will have more wealth with which they can acquire bonds. Secondly, if the interest rates have a likelihood of reducing, this will make investors acquire more bonds so that they resell them in the future at a higher price when the market interest rate drops. Inflation affects the demand function too. If there is a possibility that the rate of inflation is likely to increase in the future, people will purchase fewer bonds, more so for long-term yield bonds. Other factors include; the market becoming more stable, when the liquidity of the bond market increases significantly and a reduction in the information costs.

Supply function for bonds

When the market interest rates reduce, there is an increase in the price levels. The interest rate of a bond is inversely proportional to the price of the bond. Therefore, the supply function has a positive slope. When there is an increased in the expected profits, the supply of bonds will increase as well. More profits means the business has more cash to acquire assets. In most cases, businesses issue bonds for assets when there are pro...