Macroeconomic Impact On Business Operations

Running head: MACROECONOMIC IMPACT ON BUSINESS OPERATIONS

Macroeconomic Impact on Business Operations

Tourea B. Robinson

University of Phoenix

MBA/501

Kenneth Smith

November 26, 2006

Macroeconomic Impact on Business Operations

This paper will discuss the objective of monetary policy and its influence on the performance of the economy as it relates to such factors as inflation, economic output, and employment. 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 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.

According to the Purposes and Functions of the Federal Reserve System, monetary policies are spelled out in the Federal Reserve Act. Monetary policy is conducted by the nation's central bank, the Federal Reserve System (Fed). According to Brue & McConell, the Fed has three tools of monetary control it can use: open market operations, reserve ratio/requirement and discount ratio.

Most often, open market operations is used. Open-market operations are the Fed's most important instrument for influencing the supply of money (Brue & McConnell, 2004). These operations consist of the Fed buying and selling previously issued U.S. Government securities, or IOUs of the Federal Government. The reserve ration/requirement is the percentage of certain types of deposits that banks must keep on hand, in their own vaults, or on deposit at a Federal Reserve Bank. The Fed has the authority to set reserve requirements on checking accounts and certain types of savings accounts. Lastly, the discount rate is the interest the Federal Reserve Banks charge on the loans they grant to commercial banks. Changes in the discount rate typically occur in conjunction with changes in the federal funds rate. Through the discount rate, Federal Reserve Banks lend funds to depository institutions. All depository institutions that maintain transaction accounts or non-personal deposits subject to reserve requirements are entitled to borrow at the discount rate. The Fed implements these tools to set the nation's monetary policy to promote the objectives of stable prices, moderate long-term interest rates, and maximum employment.

When prices are stable and believed likely to remain so, the prices of goods, services, materials, and labor are not distorted by inflation and therefore contribute to higher standards of living. Additionally, stable prices foster saving and capital formation, because when the risk of erosion of asset values resulting from inflation and the need to guard against such losses--are minimized, households are encouraged to save more and busi¬nesses are encouraged to invest more (Board, n.d.).

Beyond influencing the level of prices and the level of output in the near term, the Fed can contribute to financial stability and better economic performance by containing financial disruptions and pre¬venting their spread outside the financial sector. Modern financial systems are complicated and may be vulnerable to wide-scale systemic disruptions. The Fed enhances the financial system's resilience to these types of disruptions through regulatory policies geared at banking institutions and payment systems. If a threatening disturbance develops, the Fed also cushions the impact on financial markets and the economy by aggressively and visibly providing liquidity through open market operations or discount lending.

The Federal Open Market Committee (FOMC) exercises a great deal of control over the federal funds rate through its influence over the supply of and demand for balances at Federal Reserve Banks. The initial link in the chain between monetary policy and the economy is the market for balances held at the Federal Reserve Banks. The FOMC sets the federal funds rate at a level it believes will foster financial and monetary conditions consistent with achieving its monetary policy objectives, and it adjusts that target in line with evolving economic developments. A change in the federal funds rate, or even a change in expectations about the future level of the federal funds rate, can set off a chain of events that will affect short-term and long-term interest rates, the foreign exchange value of the U.S. dollar, and stock prices. In turn, changes in these variables will affect spending decisions, thereby affecting growth in aggregate demand and the economy.

Short-term interest rates are affected not only by the current level of the federal funds rate but also by expectations about the overnight federal funds rate over the duration of the short-term contract. As a result, short-term interest rates could decline if the Fed surprised market participants with a reduction in the federal funds rate, or if unfolding events convinced participants that the Fed was going to be holding the federal funds rate lower than had been anticipated.

Long-term rates are affected not only by changes in current short-term rates but also by expectations about short-term rates over the rest of the life of the long-term contract. Generally, economic news or statements by officials will have a greater impact on short-term interest rates than on longer rates because they typi¬cally have a bearing on the course of the economy and monetary policy over a shorter period; however, the impact on long rates can also be con¬siderable because the news has clear implications for the expected course of short-term rates over a long period.

Changes in long-term interest rates also affect stock prices, which can have a pronounced effect on household wealth. Investors try to keep their investment returns on stocks in line with the return on bonds, after allow¬ing for the greater risks of stocks. For example, if long-term inter¬est rates decline, then, all else being equal, returns on stocks will exceed returns on bonds and encourage investors to purchase stocks and bid up stock prices to the point at which expected risk-adjusted returns on stocks are once again aligned with returns on bonds. Moreover, lower interest rates may convince investors that the economy will be stronger and profits higher in the near future, which should further lift equity prices. If the economy is showing

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