Equity contracts are contracts in which the principal (shareholders) and agents (managers) have equal claim to profits and assets of the firm. Shareholders own a large fraction of the firm’s equity as compared to the managers therefore most of the profits that accrue to the firm will be shared among shareholders. Managers will therefore strive to achieve their own goals rather than maximize the profits of the firm. This gives to conflict of interest between the shareholders and managers as their objectives are contradicting. The shareholders seek to obtain maximum return for their investment whereas the managers will seek to pursue their benefits such as increasing their salaries which directly impacts on reducing the returns that accrue to shareholders. The principal-agent problem brought about by equity contract has the following remedies:
Monitoring. The shareholders monitor the actions of the managers by hiring auditors who go through the book of accounts of the firm to identify any form of loopholes on them
Government regulation. The government sets up general accounting principles that are guidelines for the managers in preparing the books of accounts. This reduces the probability of managers understating the shareholders profit levels. The government also stipulates harsh penalties on managers that hide or steal profits.
Venture intermediation. The firm pools funds from other resources which are invested in new capital ventures. The new capital ventures generate more returns to shareholders and diversify the risk of managers hiding the profits of the firm.
Debt contract. Debt contract is an agreement by an individual or firm to pay an agreed amount of money that was lent at given period. A debt contract regulates the managers as the firm’s profit level is usually checked by the lender to assess the liquidity position of the firm in paying the debt.
Free Rider Problem in Debt Market
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A debt market is a market where securities such as bonds are traded. Bondholders provide capital to firms by buying the firm’s bonds. Bondholders issue restrictive covenants to the firm to avoid misappropriation of the loanable funds to non-viable projects. The restrictive covenants are effective when they are monitored and enforced by the bondholders themselves. The free rider problem arises in debt market when some bondholders do not monitor and enforce the restrictive covenants because other bondholders are already monitoring the firms. Other bondholders may follow suit in free riding therefore leads to ineffective implementation of the restrictive covenants.
Actions bank manager should take if there is unexpected deposit outflow of £50 million and the expected reserve ratio is 10%
When the bank has unexpected cash outflow of £50 million the bank will be facing liquidity problems and therefore the bank manager should formulate certain mitigating measures to protect the bank from liquidity constraints such as:
Overnight Loans. The bank manager borrows overnight loans from the central bank for expansion of its cash base. The central bank acts as the lender of last resort to commercial banks. The bank can therefore seek a loan from the central bank and pay back after its liquidity position is stabilized.
Increase the Lending Rates. The bank manager of increasing the lending rates to its customers that it lends loans can also increase its cash base. Increase of interest rates on loans reduces the probability of loans being issued this maintains the banks loanable funds. The increase in interest rates also increases the returns that the bank gains from issuing the loans.
Adverse Selection in Lending
Asymmetry of information causes adverse selection. One party is therefore more knowledgeable about the products and market conditions than the other. The banking industry has both risky and non-risky borrowers of loan. Risky borrowers prefer high level of interest rates while non-risky borrowers have preference for low interest rate. The banks cannot identify the borrowers thus charge a single and average interest rate of the two levels of interest. The non-risky borrowers therefore pay high interest rate than their desired level. This can push the non-risky borrowers out of the market as they cannot afford the average interest rates that’s higher than their optimal level of interest rate
Specializing in lending can reduce adverse selection in the banking sector. This is done by assortative matching. Banks will require that loans are only issued in groups. Borrowers will partner according to their levels of risky as they have adequate information about the risk levels of other partners in the group. The bank will have achieved its goal of sorting the risky and non-risky borrowers thus will charge different rates of interest rates according to the risk level.
Inflation targeting is monetary policy by the central bank in which it projects a given level of inflation rate that is to be achieved and maintained in an economy. The central bank thus employs other monetary policies such as interest rates to steer the current inflation rate to the desired level of inflation. Inflation targeting is therefore closely related to the following factors:
Interest rates. The interest rates in an economy directly determine the level of inflation. The central bank can either reduce or increase the bank rates so as to achieve the desired level of inflation. The central bank raises interest rates when the inflation rate is above the targeted level, this would therefore lead to progressive decrease of the inflation rate.
Money Supply. The central bank is the sole producer of money in an economy. The central bank usually changes the quantity of money in circulation to influence the inflation rates. High money supply in the economy tends to increase the inflation rate and low money supply reduces the inflation rate through interest rate mechanism
Prices of Commodities. The general increase in prices of commodities in an economy leads to high inflation rates in the economy. Central bank uses monetary policies to regulate the level of prices in the economy
Aggregate Demand and Government Expenditure. Demand and supply should be in equilibrium in an economy. When aggregate demand is high than aggregate supply, prices of commodities rise. The central bank acts as an advisory agent on fiscal policy measures that increase or reduce the aggregate demand. Increase in government expenditure increases aggregate demand; therefore, leads to general increase in prices; hence, the central bank is able to achieve the targeted inflation rate
Foreign Exchange Rate. The central bank plays a significant role in the foreign exchange market by determining favorable exchange rates. This is done through buying and selling of foreign currency. This affects the money supply and inflation rates through a chain mechanism. When the inflation rate is above the target level, the central bank buys local currency in exchange of the highly demanded foreign currency. This leads to reduction in money supply thus leads increase in inflation rate.
Advantages of Inflation Targeting
- The central bank smoothens the economic cycle thus there is no boom and bust periods in the economy
- The central bank avoids the economy from experiencing high inflation rates that have adverse effects such as reduce the desire to save and increase the cost of living
- The central bank is able to achieve the level of employment by regulating the inflation rates as high inflation leads to low levels of unemployment
- Expectations of people in the economy do not match the target inflation. When the central bank sets the target inflation at given rate people expectations will be lower than the targeted therefore suffer from money illusion but with no set inflation rate the expectations of people will be high thus demand high wages
Disadvantages of Inflation Targeting
- Inflation is factor determined by several factors within and outside the economy therefore measures to alter the interest rate may at times not change the inflation rate
- Inflation targeting on focuses on achieving stability
- Inflation targeting is an ineffective monetary policy tool as compared to national income targeting as it does not address the problem of supply and terms of trade shocks effectively
Freedman, C., & Laxton, D. (2009). Why inflation targeting?. Washington, DC: International Monetary Fund (IMF).
Solomon, S. S., & Marshall, C. W. (1992). Bonds (2nd ed.). Hauppauge, N.Y.: Barron’s Educational Series.
Stewart, J. (1995). Adverse selection and pay equity. Washington, D.C.: U.S. Department of Labor, Bureau of Labor Statistics, Office of Employment Research and Program Development.
Weygandt, J. J., Kieso, D. E., & Kell, W. G. (1996). Accounting principles (4th ed.). New York: Wiley.