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Fiscal vs Monetary Policy

Fiscal vs Monetary Policy

What is Fiscal Policy?

Fiscal policy is essentially how the government decides to collect and spend money to impact the economy. This is studied in Macroeconomics to better understand the relationship between the economy and governmental influence. The study of fiscal policy is useful in speculating the reaction to changes in the government’s budget. It is also a frequent topic during presidential elections, because fiscal policy affects numerous industries.

For businesses, fiscal policy can be very important. Some businesses are directly impacted by government interaction in the economy. For example, businesses that have government agencies as their clients depend upon a fiscal policy that includes their services. Furthermore, other businesses are impacted by fluctuating taxes. Some industries are more exposed than others to taxes. So it is very important that the leadership of businesses takes these macro-elements into consideration.

Expansionary Fiscal Policy

There are three phases of fiscal policy that the government switches between depending on the outlook of the economy. Use the term expansionary fiscal policy when the government is spending more than it is receiving. Generally, this stimulates the economy during a recession or downturn. At the onset of a recession, high government spending with no rise in taxes is common. Then increased taxes and decreased spending follows. If this phase of fiscal policy does not work, it can leave the government in a greater deficit without a recovered economy.

Contractionary Fiscal Policy

Contractionary fiscal policy is the opposite of expansionary. It involves spending less than the government collects in taxes. Rather than attempting to stimulate the economy, this phase restrains the economy. This includes controlling inflation and paying down debt. Another tool of contractionary fiscal policy is raising taxes. When the government raises taxes, households have less disposable income while the government has more to spend.

Neutral fiscal policy is the phase between expansionary and contractionary fiscal policies. This is a period of time when the government’s spending is approximately the same as its collections. This phase is often a transition period between expansionary and contractionary policies, so it is a time of speculation and uncertain governmental policies.

What is Monetary Policy?

Use monetary policy to describe the decisions over a nation’s money supply. In the United States, the Federal Reserve has this duty. The key decisions affecting monetary policy are setting interest rates, setting bank reserve requirements, and buying/selling government securities. Thus, the same agency as fiscal policy does not control the monetary policy.

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Fiscal vs Monetary Policy

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Fiscal vs Monetary Policy

See Also:
Generally Accepted Accounting Principles (GAAP)
Economic Drivers to Watch

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Rule of 72 Definition

Rule of 72 Definition

The rule of 72 definition is an approximation tool used to determine the amount of time it will take for money to double on the earnings of compound interest. The Rule of 72 is also used to calculate the rate of return necessary to double an investment in a specific amount of years.

Rule of 72 Explained

The rule of 72 is essentially an estimation for determining the amount of years or the doubling time of an investment. This is done by taking the interest available on the investment and dividing it by 72. Rule of 72 investing is usually fairly accurate. It is even more accurate with lower interest rates than it is for higher ones. Use he rule of 72 for compound interest situations. If the investment earns a simple interest at the end of the investment term, then this rule is not a very good indicator. The rule of 72 is most useful if an investor cannot perform an exponential function and simply needs to do simple math for an estimate of an investment.

A lower compound interest rate means that the investment will take longer to double. Whereas, a higher interest rate means that the investment will be doubled quicker. Thus, a higher interest rate and a lower doubling time are necessary for an investment to grow faster. Usually, a riskier investment will yield a higher interest rate and a higher return in less time. If you are planning on saving or investing your funds, then it is important for you to compare different interest rates so that you can maximize the value of your investment in the shortest amount of time. Since the rate of returns for investments vary with time, use the Rule of 72 as a quick tool. But do not use it as a full solution for analyzing the future value of investments.

Rule of 72 Formula

The rule of 72 formula is as follows:

Doubling Time (# years) = 72/Interest Rate

Rule of 72 Example

What is the doubling time for an investment with a compound interest rate of 8%? A person using the rule of 72 equation would find the doubling time equal to 9 years. Calculate this by taking 72 and dividing it by 8. By performing this the investor can tell that it will take approximately 9 years to double the principal. It is fairly accurate as the exponential function yields an actual doubling time of 9.006 years. If you want to calculate the interest rate necessary to double your funds for a specific number of years, then divide 72 by the doubling time (# years).

 

Rule of 72 Definition

 

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What is Compound Interest?

See Also:
Effective Rate of Interest Calculation
When is Interest Rate Not as Important in Selecting a Loan?
Interest Expense
Nominal Interest Rate
Interest Rate Swaps

What is Compound Interest?

Compound interest is interest earned on the principal plus interest earned on prior interest. Compounding interest rates not only earn interest on the original money, but also on the interest itself. The interest earns interest. Or, as Benjamin Franklin put it, “The money that money makes, makes money.”

For example, if an investor invests $100 at a 10% interest rate compounded yearly, during the first year the investment would earn interest on the original $100, and the next year the investment would earn interest on the original $100 plus the $10 of interest earned in the prior year.


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Compounding Periods

You can compound compound interest at different intervals, such as yearly, semi-annually, quarterly, monthly, daily, or continuously.

For yearly compounding interest rates, the original capital earns interest at the stated annual rate over the course of the year. The following year, the interest earned during the first year is added to the original capital, and the investment earns interest on the new amount.

For semi-annual, quarterly, monthly, or daily compounding interest rates, the original capital earns interest for the stated time period. At the end of that stated time period, the interest earned is added to the capital, and for the next period interest is earned on that new amount. This continues and the amount of money that earns interest gets larger and larger each period.

For a continuously compounding rate, the compounding period is an instant. In this case, compound the interest an infinite number of times during the course of a year.

Compound Interest and Simple Interest

There is a difference between compound interest and simple interest. An investment with compound interest grows faster than an investment with simple interest. Simple interest is interest earned on the original amount of capital. Each time period, the stated interest rate applies only to the principal amount. With simple interest, the interest itself does not earn interest.

For example, if $100 is invested at 10% yearly simple interest rate, then the investment earns $10 of interest each year. Each year, the interest rate applies only to the original $100 dollars and not to the accumulating interest.

Compound interest, as stated above, earns interest on the principal as well as the interest earned in prior periods. For example, if an investor invests $100 at a 10% interest rate compounded yearly, during the first year the investment would earn interest on the original $100, and the next year the investment would earn interest on the original $100 plus the $10 of interest earned in the prior year.

Compound Interest Formula

Here is how you calculate the value of an investment with compound interest after a certain number of years. First, divide the annual interest rate by the number of compounding periods. Then add one to that number. Next raise that value to the product of the number of compounding periods multiplied by the number of years of the investment. Take the value, and multiply it by the principal value. This gives you the ending value of the investment including compounded interest.

Investment Value = Principal x (1 + (Annual Rate/Periods))periods x years

Compound Interest Monthly Formula

Use the following formula to calculate compound interest on a monthly basis:

Investment Value = Principal x (1 + (Annual Rate/12))12

For example, if you invest $100 at an annual rate of 6% that compounds monthly, then at the end of one year, the value of the investment would be $106.17.

$106.17 = $100 x (1 + (.06/12))12

Compound Interest Formula Quarterly

Use the following formula to calculate compound interest on a quarterly basis:

Investment Value = Principal x (1 + (Annual Rate/4))4

For example, if you invest $100 at an annual rate of 6% that compounds quarterly, then at the end of one year, the value of the investment would be $106.14.

$106.14 = $100 x (1 + (.06/4))4

compound interest

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Interest Rate in Selecting a Loan

Interest Rate in Selecting a Loan

Why is the interest rate in selecting a loan not the best indicator? First off, the interest rate is always important. It determines the size of your loan payments.

There are, however, other considerations which may lead a borrower to not select the loan with the lowest interest rate.

Flexibility

A lender who is willing to structure the terms of a loan more favorably from the borrower’s perspective may be offering a more attractive deal than a competing loan with a lower interest rate and more stringent terms.

Experience

A banker who understands the nuances of your company’s industry and has contacts within the industry may make a loan at a higher interest rate worth it. In addition, if you are considering a potential sale of your business a lender experienced in such transactions may make for a much smoother transaction.

Turnaround

Often it is crucial to have expedited access to borrowed funds. A lender who can process your loan within a short period of time may be your best option.

Relationship

Does the prospective lender have a significant interest in obtaining your business due to their size or their desire to enter a new industry? This may afford you the opportunity to establish a relationship and eventually obtain more favorable terms, including a lower interest rate in the future for your borrowing needs.

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interest rate in selecting a loan

See Also:
What is Compound Interest
Effective Rate of Interest Calculation
Interest Expense
Nominal Interest Rate
Interest Rate Swaps

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Treasury Inflation Protected Securities

Treasury Inflation Protected Securities

Treasury Inflation Protected Securities or TIPS for short are debt instruments that are issued by the U.S. government. TIPS are indexed with the Consumer Price Index (CPI), and adjust accordingly to the inflation rate presented in the CPI.

Treasury Inflation-Protected Securities (TIPS) Explained

Treasury TIPS means that the security will adjust for inflation or deflation on whether the CPI increases or decreases. Because of this extra protection from inflation rates, TIPS owners are forced to pay more in taxes, a major disadvantage, when the security matures or it is sold. Treasury tips are normally sold with 5, 10, or 30 year maturities in denominations of $1,000 or more.

Treasury Inflation Protected Securities (TIPS) Example

Timmy has just invested in a TIPS note which has a 4% rate of return and a 10 year maturity. The following results are how an inflation protected security react to inflation and the market.

If interest rates rise by 1% in the first year then the principal would change to $1,010 (1,000 * 1.01). Thus the coupon rate would be calculated by taking 4% * $1,010 which equals a coupon payment of $40.40.

If the interest rates were to rise again by 2% then the new principal would change to $1,020 ($1,000 * 1.02), and the coupon payment would be 4% * $1,020 which equals $40.8.

Note: The new coupon payment and interest will change in the same manner no matter if deflation or inflation occurs.

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treasury inflation protected securities
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treasury inflation protected securities

See Also:
Treasury Securities
Treasury Notes (t notes)

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Subordinated Debt

See Also:
Mezzanine Debt Financing (Mezzanine Loans)
Collateralized Debt Obligations
Outstanding Debt
Self-Liquidating Loans
Loan Term
What Your Banker Wants You to Know
Alternative Forms of Financing

Subordinated Debt Definition

Subordinated debt is a security which has a residual claim upon a company’s assets, after the senior debt holders have had their claims satisfied.

Meaning of Subordinated

Subordinated debt is usually taken on by a company who cannot reach better financing opportunities. Whereas, subordinated debentures often contain a higher interest rate due to the risky nature of the securities to investors. Investors would simply refuse to take on a security that has a residual claim on the assets unless the company were willing to pay more. This is also why many companies use this as a last option in financing because of the high costs involved.

Subordinated Example

For example, Parent Co. made an acquisition of Subsidiary Co. a year ago in a leveraged buyout (LBO) for $100 million. They were able to gain a loan from the bank with low interest rates at 5% for $75 million, and was offered a Line of Credit for $50 million. Parent Co. has recently had some trouble cutting costs and getting Subsidiary to run smoothly. Thus, they have used up the rest of its line of credit.

Parent Co. is looking to go public with an IPO soon. But they need financing now to stretch the company until it is able to provide a public offering. Therefore, Parent Co. receives subordinated debt at a rate of 8% for another $50 million. This is at a higher cost to the company/. But they can use it to postpone the debt woes until the company is able to make a public offering in the market. They can then use equity money to pay off the subordinated securities as well as the line of credit.

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Stagflation

See Also:
Economic Indicators
Balance of Payments
Supply and Demand Elasticity
The Feds Beige Book
What are the Twin Deficits?

Stagflation Definition

In economics, stagflation refers to the combination of stagnation and inflation. Stagnation refers to slowing economic growth or recession. It is a period of low gross domestic product and high unemployment. Inflation refers to rising consumer prices. The combination of these two conditions makes for a troubled economy.

The term stagflation was first used by economists in the 1970s when both the U.S. and the U.K. were experiencing simultaneous stagnation and inflation. At that time much of the economic trouble was due to rising oil prices which can contribute to both inflation and stagnation.

Central Banks and Stagflation

Central banks have certain tools for counteracting unfavorable economic conditions. They can implement monetary policy tools to try to influence the conditions of the economy. Central banks can raise or lower interest rates, raise or lower reserve requirements, and buy or sell currency to influence money supply.

For example, if inflation is rising, a central bank can raise interest rates, raise reserve requirements, or purchase currency to reduce the money supply in an attempt to curb inflation.

And during a period of stagnation, if the economy is slowing down, the central bank can lower interest rates in an attempt to increase the money supply and stimulate business and economic activity.

Stagflation Dilemma

However, when inflation and stagnation occur simultaneously, the tools of the central bank are not so simple to implement. For example, during a period of stagflation, a central bank could raise interest rates to fight inflation. But this would hurt the struggling economy. And the central bank could lower interest rates to stimulate the economy, but this would exacerbate inflation.

So one of the main reasons stagflation is such a problem is that central bank monetary policy is essentially unable to ameliorate the unfavorable economic conditions. Trying to fix one half of the problem only makes the other half of the problem worse. Additionally, it doesn’t matter which side of the problem they attempt to correct or influence.

stagflation

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