Macroeconomic Impact On Business Operations

Macroeconomic Impact on Business Operations

University of Phoenix

MBA 501: Forces Influencing Business in the 21st Century

October 16, 2006

The term "monetary policy" refers to the actions undertaken by a central bank, such as the Federal Reserve, to influence the availability and cost of money and credit to help promote national economic goals. The Federal Reserve Act of 1913 gave the Federal Reserve responsibility for setting monetary policy (Author Unknown, 2006 ¶1).

The Federal Reserve controls the three tools of monetary policy--open market operations, the discount rate, and reserve requirements. The Board of Governors of the Federal Reserve System is responsible for the discount rate and reserve requirements, and the Federal Open Market Committee is responsible for open market operations. Using the three tools, the Federal Reserve influences the demand for, and supply of, balances that depository institutions hold at Federal Reserve Banks and in this way alters the federal funds rate. The federal funds rate is the interest rate at which depository institutions lend balances at the Federal Reserve to other depository institutions overnight.

Changes in the federal funds rate trigger a chain of events that affect other short-term interest rates, foreign exchange rates, long-term interest rates, the amount of money and credit, and, ultimately, a range of economic variables, including employment, output, and prices of goods and services (Author Unknown, 2006 ¶2).

According to the University of Phoenix simulation (2006), the Discount rate (DR) and the Federal Funds Rate (FFR) has an inverse relation to each other and impact on the money supply circulating in the economy. Banks are inclined to borrow from the Feds if the DR charged by the Fed is lower than the FFR charged by other banks. As the DR is decreased, banks shift their source of borrowing from other banks to the Feds, which increases the amount of money in circulation. The inverse of this relationship holds true as well. The Required Reserve Ratio (RRR) represents the percentage of deposits that any bank holds as reserves in vaults or with the Feds. The Feds mandate this ratio. If the ratio is decreased, banks are required to hold lesser amounts in reserve that increases the amount of money in circulation. The inverse of this relationship also holds true. Open market operations are comprised of T-bills, bonds and other federal instruments that are sold to investors. Sales of these instruments typically drain money out of the system. Similarly, buying these instruments releases money into the system (Simulation, 2006).

The money supply has affects on the macro-economic indicators. Three of the leading economic indicators are the Real Gross-Domestic Product (GDP), the inflation rate and the Unemployment rate. The GDP increases with an increase in the money supply. Higher levels of money in the system act as a spur for investment and consumer/industrial demand. This, in turn increases the nation's real GDP. Increasing the money supply will increase the rate of inflation. When the amount of money in the system is increased, the nominal value of money remains the same. However, as more money chases the same quantity of goods and services, the real value of money is decreased. As a result, prices go up, thereby signaling greater inflation rates. The unemployment rate is inversely related to GDP. Due to increased investment and spending, the demand and employment opportunities for the workforce go up, since labor is required for the production of goods and services. As the GDP goes up, the unemployment rate tends to go down. Similarly as money is drained out of the system, GDP tends to fall; the demand and employment opportunities fall, thus putting pressure on the unemployment rate to increase (Simulation, 2006).

This is how the Federal Reserve controls the money supply and how they affect macroeconomic factors. But how is money created? The process begins with the Fed who controls the amount of currency that gets into the system. Actually it is the mint, an arm of the US Treasury Department that prints the money and then sends it to the Federal Reserve but that is a finer point we need not concern ourselves with at this time. It is the Fed who puts the money into the system and the currency it supplies is called high-powered money. This is what the Fed directly controls but it is not the money supply. The high-powered money ends up in two places - the vaults of the banks as reserves, or the pockets of people and businesses as cash (Author Unknown, 2003).

Given the nature of the banking system, it is the banks that actually create money. The cash held by the banks is called reserves and these reserves are the base for banks' expansion of checking accounts. If you add the currency held by the public with the deposit (checking) accounts created by the banks, you have the money supply (Author, Unknown, 2003).

U.S. monetary policy affects all kinds of economic and financial decisions people make in this country--whether to get a loan to buy a new house or car or to start up a

company, whether to expand a business by investing in a new plant or equipment, and whether to put savings in a bank, in bonds, or in the stock market. Furthermore, because

the U.S. is the largest economy in the world, its monetary policy also has significant economic and financial effects on other countries (McConnell & Brue, 2005).

Monetary policy can be used to influence the performance of the economy, as reflected in such factors as inflation, economic output, and employment. It works by affecting demand across the economy--that is, the population's willingness to spend on goods and services (McConnell & Brue, 2005).

Both fiscal and monetary policies affect aggregate demand. But because discretionary fiscal policy changes in the U.S. are often difficult to enact in a timely fashion, automatic fiscal stabilizers and discretionary monetary policies are commonly viewed as the primary policy tools for macroeconomic stabilization. However, there are situations in which monetary policy might be unable to stimulate the economy, and discretionary fiscal policy would be needed to combat a recession (McConnell & Brue, 2005).

Monetary policy is one of the tools that a national Government uses to influence its economy. Using its monetary authority to control the

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