Table of Contents
Essay Question (i)
Essay Question (ii)
Essay Question (iii)
The stock market is a market where an investor buys and sells shares or stocks via brokers or electronic trading platforms. These shares represent claims on the ownership of the businesses (Sulthan, 2017). The changes in stock market prices can have both a positive or negative impact on consumer spending and businesses. Stock represents a major portion of an individual's wealth that is an individual (especially in the US) generally keeps a significant portion of wealth in stock.
Stock Market prices and economic activity in the country moves in the same direction i.e. when the price of the stock market rises (bull market) then this means that economy is also growing. The increase in the prices of stocks raises the investor and consumer confidence about the future market conditions which increases their level of spending. A person feels wealthier as there is a rise in the value of their portfolio and they increase spending on expensive items like houses or cars. They increase their spending because they are confident about their financial wealth and producers also increases their production level because of the increased revenues from consumers (Simpson, 2014). There is the entry of new investors in the market as they have positive confidence about the future prices of the stock and businesses also increase their level of investment as prices of their stock rise. Thus, consumer spending increases when there is a rise in stock market prices.
When the stock prices increase, it represents a strong economy which includes consumer spending as well. The increase in stock prices also causes a wealth effect. The increased stock prices increase the expenditure by consumers as their real wealth rises and the resource constraints faced by them get relaxed. So, when the price of the stock starts rising, then the wealth of the individual also rises. Since consumer spending is positively affected by wealth, the increase in wealth from a higher price of the stock will cause an increase in consumer spending (Pettinger, 2017). At the point of expanding stock costs, stock owners see an expansion in wealth as being more similar to the consumption of building utilization. Consumer spending depends on nature and the expectations of the market. In the case of a bull market, consumers spend more since they are earning more profits following the strong economic growth, while during bear markets, they spend less due to fear of losing their wealth. The rise in stock prices is associated with more significant economic development and bull market. Investor's confidence to invest their money increases due to high return chances caused by increased stock prices. As a result, consumer spending will increase as they buy more goods and services due to increased wealth caused by an increase in the stock market prices. Increased consumer spending causes businesses to increase supply to meet and satisfy the consumers' needs hence growing revenue in the market (Piros & Pintos, 2013).
A business cycle refers to the fluctuations in the gross domestic product around the long-term GDP. The rate of money supply growth changes with the business cycle. Business Cycle in simple words can be understood as alternate expansion and contraction in economic activities, aggregate output, income, employment, and price level (Sherman, 2014). There is a wave-like fluctuation of cyclical booms and depressions. Money supply growth expands during the rise in the business cycle when the economy experiences inflationary trends. Money supply growth falls when the business cycle starts falling or when the economy slows down, heading towards a recession. A recession is a period of negative economic growth. Before the recession, the economy is at the peak where money supply growth is highest. The money supply growth tends to fall before the recession finally sets in.
Just before the recession, the economy's money supply collapses as people spend less and the money velocity goes down (Kehoe, Madrigan and Pastorino, 2018). During the recession, the money supply will slow down while at the peak of business the supply of money will be less. Therefore, the business cycle determines the flow of the supply of money. In the business cycle, money supply growth will be less, and then it slows down during the recession. The diagram attached shows the peaks of the business cycle. The straight line indicates the economy; it is always growing while money velocity goes up and down.
When there is a boom in the economy, the growth rate of money supply increases as the economic activity increases which ensures a surge in income and level of output. The rate of money supply growth focuses on the growth of the rate of prices in the economy while the business cycle shows the trend of GDP in the long-run. This further increases the economic activity and the cycle continues (Koo, 2014). Thus, the money supply grows at a rate that is much faster. Before the recession, the increment of the supply of money slows down as the economic activity decreases which decrease the income and output which follows to a fall in the money supply.
Monetary Authority of the country controls the supply of money growth in the economy to maintain high economic growth, low inflation rates, low unemployment rate, and stable interest rates. The Monetary Theory of Business Cycle believes that phases of the business cycle are an outcome of changes in the credit or money supply conditions in the economy and business cycles are alternate phases of inflation (or boom) and deflation (or recession). The changes in the level of monetary and financial activity in the country occur due to a change in the flow of money.
When the Monetary Authority of the country increases the money supply in the economy than interest rate decreases which means credit is available at cheaper rates and individuals or organizations to increase their level of spending (Gali, 2015). This increases output, income, employment opportunity, and prices in the economy, and the economy moves into the phase of economic expansion or boom. This is shown with the help of the diagram below:
Initially, the economy is at point E, that increments in the money supply deviate the aggregate demand curve to the right from AD1 to AD2 and a new equilibrium is reached at point E'. This increases the income level from OY to OY' and price level from OP to OP'.
When the Monetary Authority of the country decreases the money supply growth in the economy than interest rate increases which means credit is available at higher rates and individuals or organizations to decrease their level of spending. This decreases output, income, employment opportunity, and prices in the economy, and the economy moves into the phase of economic recession. This is shown with the help of a diagram below:
Initially, the economy is at point E, decreases in the money supply deviates the aggregate demand curve to left from AD1 to AD2, and a new equilibrium is reached at point E'. This decreases the income level from OY to OY' and price level from OP to OP'.
Thus, the money supply can be understood as the total amount of money that is in circulation in the economy. When there is a boom in the economy, the growth rate of money supply increases as the economic activity increases which lead to a rise in the level of income and output. This further increases the economic activity and the cycle continues. Thus, the money supply grows at a fast rate. Before the recession, the growth of the money supply slows down as the economic activity decreases which decrease the income and output leading to a fall in the money supply. On comparing the growth in the money supply over the last few decades, one can say that the money supply is a major driving force behind each boom and recession in business. In simple words, it can be said that the money supply has been rising sharply just before the business boom (that is period of increase in GDP growth) and declining just before the business recession (that is period of negative GDP growth). As the economy shows inflationary patterns, cash providing development can beat all grow in the midst of the trade cycle ascending (Economics Discussion, 2017). Money for development can fall as soon as the economy retreats and turns to subsidence. Simply before the withdrawal, money can flow around the economy, as people can pay less, so the speed of money can fall. The business cycle can determine the streaming money provide. Money provides development at the top of a trade cycle is less, and it will backpedal in the midst of subsidence.
Interest rates typically differ for three months treasury bills, long-term treasury bonds, and Baa and corporate bonds. But first, it is important to know what these three are.
Three-month Treasury bills are investments taken by the investor for a short period of time. This is a debt obligation supported by the government. In this very less, interest fluctuates.
Long term treasury bonds are investment taken by the investor for a longer period of time, it usually lasts for a period of more than 10 years. In this interest rates are fixed and don’t usually change.
Baa corporate bond is not particularly a bond as the name suggests but instead it is rather different. Baa is the rating given to the bond by am credit agency. This implies the trust of the customers or investors to invest in that particular bond. Interest rates for these bonds are high.
These three are defined as below:
As discussed treasury Bonds are short-term financial instruments that are issued by the Federal government to finance their immediate needs of spending or financing deficit. These are the safest instruments as the U.S. government never defaults and these bills are highly liquid. There is a high demand for the Treasury bill which keeps the interest rate for treasury bills usually at a lower level. The interest rate of treasury bills fluctuates more often and remains at a lower level. Treasury Bills for a short time period have lower interest rates than Treasury bills for a long time period because when an investor invests in a long-term investment than higher interest rate is the compensation for investing his funds for a longer time period (Valderrama et al., 2012).
The interest rates of Baa Corporate Bonds are higher than the average interest rate of other securities because these bonds are riskier, less liquid, and have high default risk. These corporates have low credit ratings and are most likely to default on their bonds. So, they must compensate investors with higher interest rates then only investors will buy their bonds.
The interest rate on three-month treasury bills < Interest rate on long-term Treasury bonds < Interest rate on Baa Corporate Bonds
So, it can be said that out of these three, Baa corporate bonds give a higher interest rate than the other two. Interest rates on three-month Treasury bills change more extensively than long-term treasury bonds and Baa corporate bonds. Secondly, the Treasury bill interest rate is lower compared to the other interest rates. On the other hand, Baa corporate bonds have higher interest rates and are more rigid than other interest rates. The interest rate decreases with an increase in the period of operation, implying that the long-term Treasury bill will have the least interest rate, followed by Baa Medium and then the three-month Treasury bill.
So in short, the relationship between them is that the interest rate on three-month T-bills is the lowest since they are very liquid and they are the shortest tenure and its returns encourage people to buy them. The interest rate on Baa corporate is the highest because companies have default risk. The interest rate on the three-month treasury bills fluctuates very often. The interest rate on a long-term Treasury bond is fixed. The interest rate on Baa corporate bonds is high. The three-month treasury bills serve as short-term investments. Due to its small maturity period, the interest rates on the three-month treasury bills fluctuate very often. This occurs because the smaller the maturity period is, the higher are the fluctuations on the interest rate and the lower is the interest rate. Long-term treasury bonds have a maturity period of more than 10 years. So, it is a kind of loan to the government. Due to its long maturity period, the interest rate on these is fixed. Baa (medium quality) corporate bonds refer to the bonds that are not secured highly or poorly. They are named this because of the rating given to them. Their rating makes them trustworthy and induces investors to invest more in such a bond. So, the interest rate is high for them. It is observed that the interest rates on three-month Treasury bill experience a higher degree of fluctuation than other types of interest rates. In addition to this, they tend to be lower than that of long-term treasury bonds and Baa corporate bonds thanks to high liquidity (Appel, 2008). On the other hand, interest rates on Baa corporate bonds are highest amongst these three securities due to a high degree of default risk (as they are of medium quality and issued by corporate firms). Whereas, the rate of interest on long-term Treasury bonds lies between the rate of interest on Treasury bills and the rate of interest on corporates bonds. Ideally, long-term treasury bonds can have the lowest unit charge as they are the safest and the longest holding. The charge per unit is added only in the case of medium-quality bonds since the risk is greater once individuals invest in them. The fee per unit is the highest for 3-month treasury bills with the shortest tenure and the returns should be added to encourage individuals for them to shop.
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