Question

How does the federal reserve influence corporate finance?

Answer 1

Federal Reserve is the central bank of United States of America. Federal Reserve is in charge US monetary policy. The tools it uses to achieve its monetary policy goals are:

• Setting Reserve Requirements:
• Setting Discount rate
• Open Market operations:

Through these tools it influences the amount of funds in the banking system and interest rates.

Reserve requirement mandates the reserve the banks must keep as reserve at their vaults or at Fed. A low reserve requirement allows bank to lend more. Through multiplier effect it increases money supply multiple times and is expansionary. Similarly if Federal Reserve wants to reduce money supply (follows contractionary policy) it raises reserve requirement. This results in banking system having less money to lend.

Discount rate is the rate which Federal Reserve charges to its member banks to borrow. To ensure the required reserve requirements banks can borrow money from other banks or Federal Reserve. The market for these interbank loans of reserve called the federal funds market and the rate banks pay for the loans is called the federal funds rate. Federal Reserve can raise or lower Federal Funds rate as required. This causes interest rates in general to rise or fall.

Through open market operations Federal Reserve buys or sells securities. If it wants to raise money supply it buys securities and adds cash to banks' reserves enabling them to lend more. If it wants to reduce money supply it sells securities and reduces cash holdings with banks. Thus the banks have less money to lend.

The change in money supply and interest rates impacts corporate finance:

1. Banks lend money to corporates for financing projects/investments and working capital. Change in money supply and interest rates of banks do have direct impact on corporate finance.

2. Change in money supply impacts demand and supply of all goods. If money supply reduces consumer spending goes down which in turn will affect sales revenues of corporates.

3. Change in money supply and interest rates of banks impacts savings and investments. This will impact corporate finance.