Macroeconomic Impact on Business Operations

Running Head: Macroeconomic Impact on Business Operations

Macroeconomic Impact on Business Operations

Ramona Berry

MMPBL501/University of Phoenix

Kathleen Crump

June 6, 2010

Introduction

In this paper, the monetary policy of the Federal Reserve is examined. Monetary policy and its effect on macroeconomic factors such as general domestic policy (GDP), unemployment, inflation, and interest rates are identified. These factors are compared against one another and the adjustments that the Federal Reserve takes to adequately control adverse economic effects are discussed. Additionally, the factors of how money is created are explained and the best ways to achieve a healthy balance of economic growth, moderate inflation, and a reasonable rate of unemployment is recommended.

The Federal Reserve primarily uses three tools to control the money supply. They are:

1) buying and selling of securities from commercial banks and public, 2) changes to the bank's reserve ratios, and 3) changes to the discount rate. The most effective and widely used monetary tool is the buying and selling of securities. The least used is the changing of the discount rate due to banks not wanting to take out loans if possible. Banks play a tremendously important role in our economy. They are the distributors of money through making loans to individuals, small businesses, and corporations. In our capitalistic society, commerce is booming when businesses are implementing high-dollar capital investment projects such as highway improvement projects, school building construction projects, city landscape projects, and various others. When individuals start businesses and need a loan from the bank to provide capital for their new business venture these activities increase GDP and provide new jobs decreasing unemployment and stimulating economic growth.

First, the Federal Reserve buys and sells securities in the open market from banks or the public. This is usually T-bills, bonds, and federal instruments sold to investors. "Open-market operations are the Fed's most important instrument for influencing the money supply" (McConnell & Brue, p.270). This transaction is a very useful tool because it can influence a rise in GDP giving banks access to increased reserves, which they then can loan to individuals and businesses stimulating the economy. When the government buys securities, it lowers the prices and raises the interest rates of bonds. The reverse is true when bonds are sold. Understanding these factors can assist in addressing complex economic issues.

The buying of securities to increase money supply also has a positive effect on employment levels. When businesses and corporations have the working capital to sustain their workplaces they can afford to hire necessary staffing to increase productivity inducing demand for their products and services. An increase in money supply is usually the essential step to address recessions. During moderate to severe recessions the economy slows down, jobs are lost, production is diminished due to a lack of money supply while consumers have decreased purchasing power regardless of demand. Recession is defined as "a period of decline in total output, income, employment, and trade. This downturn, which lasts 6 months or more, is marked by the widespread contraction of business activity in many sectors of the economy.

But because many prices are downwardly inflexible, the price level is likely to fall only if the recession is severe" (McConnell & Brue, p. 134). When inflationary periods are threatening the economy, the Federal Reserve uses restrictive money policy or tight money policy to limit banking reserves and reduce spending. (McConnell & Brue) Instead of buying securities, the Federal Reserve employs the strategy of selling government securities to affect the needed changes and restrain inflation.

Secondly, the Federal Reserve has the ability to alter the requirement reserve ratio for banking institutions. Like securities, it can be used to increase or decrease the money-creating ability of banks. "Although changing the reserve ratio is a powerful technique of monetary control, it is infrequently used. The last such change was in 1992, when the Fed lowered the reserve ratio from 12 percent to 10 percent" (McConnell & Brue, p.274). If a bank has check deposits of $50,000 and the required reserve ratio is 10%, then it is required to reserve in its vaults $5,000. This $5,000 is withheld from use and cannot be loaned out to individuals and businesses to create more money.

Additionally, if the reserve ratio is raised banks will lose out on creating more money from the effects of the money multiplier, which increases the bank's ability to significantly increase its money supply. "The monetary multiplier is the reciprocal of the required reserve ratio; it is the multiple by which the banking system can expand the money supply for each dollar of excess reserves" (McConnell & Brue, p.264). When reserves are lowered, banks have more ability to positively affect GDP and be a catalyst to assist businesses in restricting unemployment levels. The opposite is true when managing inflation. Its inverse relationship to GDP growth mandates the increase of reserves, which will restrict money supply in an effort to normalize prices.

Lastly, the discount rate is another tool used by the Federal Reserve to provide monetary controls. Sometimes banks are hard-pressed for additional monies and they will create short-term loans with the Federal Reserve. "When a commercial bank borrows money, it gives the Federal Reserve Bank a promissory note (IOU) drawn against itself and secured by acceptable collateral--typically U.S. government securities. Just as commercial banks charge interest on their loans, so too Federal Reserve Banks charge interest on loans they grant to commercial banks. The interest rate they