Macroeconomic Impact on Business Operations

Macroeconomic Impact on Business Operations

The central bank of the United States is the Federal Reserve, which is composed of a federal governing agency, called the Board of Governors, and 12 regional Reserve Banks (Federal Reserve [FR], 2007). The Federal Reserve (Fed) aims to achieve and maintain full employment, economic growth, and price-level stability by implementing a monetary policy that deliberately makes changes in the money supply to influence interest rates and spending. The Fed can implement a contractionary fiscal policy, that decreases government spending and/or increases taxes, or it may implement an expansionary fiscal policy that increases government spending and/or decreases taxes to stabilize the economy as needed (McConnell & Brue, 2004). Alternatively, the Fed can implement the monetary policies of easy money or tight money. Which policy to use is influenced not only by the present economy of the United States, but also Asian and Western economies. Previous Fed Chairman Alan Greenspan stated last year that the United States could not "remain an oasis of prosperity unaffected by a worldÐ'...experiencing greatly increased stress" (Ip, Solomon, & Wessel, 2007). All economies and previous policy decisions must be considered.

The three tools of monetary control that are used by the Fed to influence policy and/or alter commercial bank reserves are a) open-market operations, b) the reserve ratio, and c) the discount rate, the most important being open-market operations (McConnell & Brue, 2004).

Government bonds are treasury securities issued by the United States Department of Treasury, through the Bureau of the Public Debt, and are the debt financing instruments of the federal government (Wikipedia, 2007). Open-market operations consist of the buying and selling of these government bonds to commercial banks and the public. When Federal Reserve Banks purchase bonds from commercial banks, the reserves of the bank are increased by the amount of the purchase as the bank gives up part of their holdings of securities. This increases the money supply or lending ability of the commercial bank. When the Federal Reserve Banks purchase from the public it not only increases actual reserves of the loaned up banking system but also the checkable deposits of the seller's personal checking account. This increase in the demand for government bonds causes a rise in the price of bonds and decrease in their interest rate (McConnell & Brue, 2004).

In retrospect, commercial banks' reserves are reduced when Federal Reserve Banks sell government bonds. The commercial bank draws against their deposits or reserves in Federal Reserve Banks reducing their reserves. This also occurs when Federal Reserve Banks sell to the public Ð'- both causing a decline in the nation's money supply. The additional supply of bonds in the market lowers their price and raises their interest rate making them a smart purchase for the public or commercial banks.

The Fed controls the reserve ratio to influence the ability of banks to lend money. The reserve ratio is the ratio of required reserves a commercial bank must maintain in Federal Reserve Banks for its own checkable-deposits liabilities (McConnell & Brue, 2004). This is done because the United States has a fractional reserve banking system where a "fraction of the total money supply is held in reserve as currency" (McConnell & Brue, 2004, Chap. 14) These reserves can protect depositors as a source liquidity when large, unexpected withdrawals are made from commercial banks. When Federal Reserve Banks lower the reserve ratio, it transforms required reserves into excess reserves and enhances the ability of commercial banks to create more money by lending. Raising the reserve ratio by the Fed forces commercial banks to reduce the amount of checkable deposits created by lending, decreasing the money supply (McConnell & Brue).

The third tool used by the Fed is the discount rate or the rate of interest that Federal Reserve Banks loan funds to commercial banks when funds are needed. By decreasing the discount rate, the Fed increases the reserves of the borrowing bank, enhancing the ability of that bank to extend credit or loans, increasing the money supply. An increase in the discount rate restricts the money supply as it discourages commercial banks to borrow at a higher interest rate (McConnell & Brue, 2004).

As previously discussed, the Fed increases money supply by purchasing government bonds from commercial banks and the public, lowering the reserve ratio for commercial banks, and decreasing the discount rate to commercial banks. The Federal Reserve then relies on commercial banks to actually create money by making loans and purchasing government bonds from the public. This is done to finance a government deficit caused by excessive spending of tax revenues (McConnell & Brue, 2004). When commercial banks or thrifts loan money they create checkable deposits that are money. This changes the composition of money by not the total supply of money. Checkable Ð'-deposit money obtained through credit can be considered debts of commercial banks and lending institutions. Initially this decreases the amount of reserves and deposits in the lending bank and creates money to individuals or the bank into which it is deposited. The lending bank will charge an interest rate on the debt that is affected by that bank's discount rate and the prime interest rate (McConnell & Brue). Lending institutions cannot lend out more than their reserve. A multi-bank system can lend or create money by a multiple of its excess reserves. Multi-bank systems can expand the money supply by applying the monetary multiplier or reciprocal of the required reserved ratio.

Money is also created when commercial banks buy government bonds from the public and/or a securities dealer. This increases the supply of money as does lending to the public. A purchased interest-bearing government bond or security appears as an asset to the bank, even though it is not real money. The purchase price becomes