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Monetary Policy - Money, Credit, the Federal Reserve, Interest Rates Essay Example

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Monetary Policy - Money, Credit, the Federal Reserve, Interest Rates

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Monetary Policy - Money, Credit, the Federal Reserve, Interest Rates. An increase in the discount rate is contractionary when it indicates that the Federal Reserve wants to raise short-term interest rates. A decrease in the discount rate is expansionary when it indicates that the Federal Reserve wants to reduce interest rates for the short term (Hubbard, 1994).
The third tool that the Federal Reserve uses to try to control interest rates is the required reserve requirements or the supply of money that banks are required to hold. An increase in the reserve requirements will reduce the available open money supply in circulation. This is because banks will be required to hold onto a larger amount of funds and not put them as available for lending or available to be put into general circulation for the public.

If nothing else changes, when the Federal Reserve increases the reserve requirements of banks, it is a contractionary policy. A decrease in the reserve requirements is expansionary policy (Hubbard, 1994).
The yield curve is a graph showing yields to maturity on different default-risk free instruments as a function of maturity (Hubbard, 1994). There is generally an inverse relationship between short term and long term interest rates as the time to maturity increases (Hubbard, 1994). Yield curves can be flat, which would indicate that the yields on the short-term obligations are the same as for the long-term obligations. In reality, the slope is usually positive or upward sloping. Short-term securities receive lower interest rates, while long-term securities receive the highest interest rates. That would indicate that the longer the wait until the obligation matures, the higher an interest rate is received (Hubbard, 1994). This seems logical since the short-term interest rates are more easily predictable, and hence less risky than those investments that are held for a long period of time. As time passes, inflation will generally increase, along with the risk that future cash flows will not be as secure as the short-term issues (Hubbard, 1994). . Monetary Policy - Money, Credit, the Federal Reserve, Interest Rates.

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References

Barry, C.B., et. al. (2005). Interest Rates and the Timing of Corporate Debt Issues. 1-50

http://sbuweb.tcu.edu/vmihov/Research/BMMRDebtTiming08312005.pdf Web. accessed

30 August 2010.

Hubbard, G.L. (1994). Money the Financial System and the Economy. 500-547.

Woodruff, T. (2010). The Basics: A borrower’s guide to forcasting interest rates. 1-3

http://moneycentral.msn.com/content/Investing/Realestate/P39219.asp Web. accessed 30

August 2010.

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