Question

1. Assuming the firm’s sales volume remained constant, would you expect it to have a higher cash balance during a tight-money period or during an easy-money period? Why? (2 pts)

2. Explain how each of the following factors would probably affect a firm’s target cash balance if all other factors were held constant. (3 pts)

a. The firm institutes a new billing procedure that better synchronizes its cash inflows and outflows.

b. The firm develops a new sales forecasting technique that improves its forecasts.

c. ​​​​​​​The firm reduces its portfolio of U.S. Treasury bills. ​​​​​​​

d.The firm arranges to use an overdraft system for its checking account.

​​​​​​​e. The firm borrows a large amount of money from its bank and also begins to write far more checks than it did in the past. ​​​​​​​

f. Interest rates on Treasury bills rise from 5% to 10%.

Answer 1

1. Assuming the firm’s sales volume remained constant, would you expect it to have a higher cash balance during a tight-money period or during an easy-money period? Why?

Ans. To answer the above question we must first understand what is tight-money period and what is easy-money period.

Tight-money Period: Tight-money period occurs when the central bank through monetary policy restrict the money supply and forms the shortage of money. It reduces the amount of credit that bank can provide to businesses or households. Further, interest rates are also high during this period as central bank is concerned about inflation and also higher interest rates discourages businesses and households to borrow money.

Easy-money Period: Easy-money period occurs when the central bank through monetary policy allows the flow of the money into banking system and facilitates the businesses and households into loan acquisition. Further, interest rates comes down as central bank is more concerned about boosting the economy and as a result businesses are encouraged to acquire loans to start economic activities and generate employement.

So, from the above discussion, it is clear that during the easy-money period firms are expected to have higher cash balance as there is more cash in the economy, money is flowing easily between the banks and also interest rates are lower whereas during the tight-money period, interest rates are high so it is expensive to hold idle cash and also the money flow in the economy is restricted.