Question

1. When does the Fed use a stimulative monetary policy and when does it use a restrictive-monetary policy? What is a criticism of a stimulative monetary policy? What is the risk of using a monetary policy that is too restrictive?

2. Should firms invest in money market securities? (elaborate on your answer)

3. Should financial institutions invest in junk bonds?(elaborate on your answer)

4. Does governance of firms affect the prices of their bonds?(elaborate on your answer)

Answer 1

1a. The Federal Bank is able to monitor and regulate the growth of money supply in the economy with the use of its monetary policy. Stimulatory or expansionary monetary policy increases the money supply in the economy. Such a policy is used in times of recession. The Fed decreases the interest rates so as to boost borrowing and consumption in the economy to counter recession. Restrictive monetary policy on the other hand is used in times of high inflation. The Federal Bank increases the interest rates so as to reduce borrowings.

A stimulatory policy may lead to high inflation since people will demand more goods thus raiseing their prices. A highly restrictive policy may make the firms uncompetitive forcing them to close down thus causing unemployment and overall slowdown in the economy.

2. 2. Firms should invest in the money market securities as an investment of its idle funds. The money market securities healed high returns and the forms will be able to benefit and give a higher return to their owners by investing in money market securities. However the investments should be made only if the firms have extra cash available for a short period. This will also provide them a certain amount of liquidity along with earning interest on the extra funds.

3. A financial institution should not invest in junk bonds. Investors trust their funds with such institutions and junk bonds are a big gamble. Investing in them and hence gambling with investors funds will be unethical and can cause a huge loss to them thus breaking their trust in the institution. Though they have a high yield, they carry a huge risk of default which can be disastrous to the business.

4. Yes. Bond prices reflect the default risk of firms. Firms with high governance are generally subject to lower default risk. Hence it increases investor confidence in the firm. They are then willing to pay a higher price for such firms.