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Macroeconomic Impact On Business Operations

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Macroeconomic Impact on Business Operations

One of the greatest macroeconomic factors influencing day-to-day business operations and overall economic conditions in any country is the governmental application of monetary policy. Monetary policy consists of the use of tools to influence the supply of available money in a given economy. Through this manipulation of money supply, a government influences other factors such as GDP and inflation as well as unemployment and interest rates. It is with monetary policy that a government can endeavor to maintain desirable economic conditions. Federal Reserve chairman Alan Greenspan described the goals and difficulties of the implementation of monetary policy in 1994 as follows.

...move toward a posture of political neutrality - that is, a level of real short-term rates consistent with sustained economic growth at the economy's potential. That level, of course, is difficult to discern and, obviously, is not a fixed number but moves with developments within the economy and financial markets. (Aspinwall 1995)

The goal of this paper is to examine the different aspects of U.S. monetary policy and analyze their effects on economic conditions. In addition, methods by which to achieve the best balance of macroeconomic factors will be discussed. Ways that money is created within the U.S. economic system will also be examined.

History of U.S. Monetary Policy

The supply of available money in the United States consists of two types: physical currency and checkable deposits. Currency consists of coins as well as paper money, also known as Federal Reserve notes. The United States Mint issues physical currency and distributes it for circulation whereas private banks create checkable deposits when they issue loans. These checkable deposits make up over 50% of the nations available money supply (McConnell and Brue 2004).

The history of monetary policy here in the U.S. can be traced back to goldsmiths in the late 18th century. Goldsmiths were the predecessors to the modern banking system that is in place today. They issued receipts for deposits of gold, which they held in their vaults. These receipts eventually became an acceptable form of currency and the smiths began to notice that the gold itself was rarely collected. With this fact in mind, goldsmiths began to issue receipts in excess of the quantities of gold that they held. This concept evolved into the banking system that is in place today. The Federal Reserve System (the Fed) was established by an Act of Congress in 1913 and consists of twelve Federal Reserve District Banks (FRBSF 1999). Today the Fed mandates the amounts of reserve that a bank is required to hold in what is called the Required Reserve Ratio (RRR). The RRR is one of several tools used by the Fed to implement monetary policy in favor of desirable economic conditions. These tools will all be discussed in further detail in the sections to come.

Macroeconomic Indicators and Influences

"The object of monetary policy is to influence the performance of the economy, as reflected in such factors as inflation, economic output, and employment" (FRBSF 1995). The Fed's monetary policy consists of three main tools that it uses to influence the supply of available money in the economy: the Discount Rate (DR), the RRR, and Open Market Operations (OMO). Releasing more money into the economy is what is known as easy money policy and will have a positive effect on macroeconomic factors such as Gross Domestic Product (GDP) and unemployment, but will also increase inflation. It is for this reason that care must be taken to achieve a proper balance of available money supply. Diminishing the supply of available money is what is known as tight monetary policy. A tight policy will have an inverse effect on macroeconomic conditions and is usually associated with a strengthening dollar (Aspinwall 1995). It is for this reason that monetary policy is closely coordinated with economic growth. It is with implementation of monetary policy that the Fed can control the US economy in an attempt to mitigate peaks and recessions and maintain prosperous economic conditions for the long-term.

Although the Fed's monetary policy tools can be used to influence to influence macroeconomic factors in the economy, there is not always a direct correlation between these factors, as table 1 shows. This is because there are many other factors at work which all have a subtle influence on the U.S. economy. Look at the U.S. GDP, for example: McConnell and Brue state the GDP is "a basic measure of an economy's economic performance, [the GDP] is the market value of all final goods and services produced within the borders of a nation in a given year" (2004). Although an increase in money supply will promote an economic trend toward the production of more capital goods, many other factors influence this economic growth. It is for this reason that we do not always see a direct correlation between the rates that the Fed mandates and these macroeconomic factors. The following table summarizes the relationship between GDP, unemployment and inflation from the year 2001 to 2005.

Table 1 - Relationship between GDP, inflation and unemployment: 2001 - 2005

Year Nominal GDP (billions) Inflation Unemployment Rate

2001 10,128 5.4% 4.7%

2002 10,470 6.4% 5.8%

2003 10,971 3.9% 6.0%

2004 11,734 4.7% 5.5%

2005 12,487 4.9% 5.1%

Note. From the website of the Congressional Budget Office, Retrieved Saturday December 2, 2006.

As this table shows, GDP consistently rises through this period, while inflation and unemployment rates are variable. However, we do see an inverse relationship between inflation and unemployment between the years of 2002 and 2005. This serves to illustrate the fact that although the Fed has tools that can be used to influence economic conditions, adjustments to money supply may or may not always have the desired results.

The Fed must make decisions as to which of its monetary goals will take priority at any point (FRBSF 1999). For example, if a tightening of policy is enacted in order to combat rising inflation, this policy could result in an increase of unemployment if it remains in effect too long. Conversely, an easy policy may serve to promote an increase of GDP and decrease of unemployment in the short-term; but if left in effect too long may result in an undesirable increase in inflation rate. Another problem with the



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