Macroeconomic Impact on Business Operations

Macroeconomic Impact on Business Operations

Warren

University of Phoenix

MBA 501

October 23, 2006

Introduction

Macroeconomics is the study of the economy as a whole. A thriving economy will create money and produce goods and services for consumption. Economic systems are influenced by macroeconomic factors. A country will strive for sustainable economic growth to improve the standard of living for its citizens. Fiscal and monetary policy is used to influence the economy. A well-defined monetary policy has the ability to control an economy and produce sustainable growth.

Money Creation

Money can be created by a government printing more money or through the banking system. When a government prints more money and spends this in the economy, the actual value of each unit of money already in the economy falls. This reduction of value for each unit of money is known as inflation. When a government prints money to finance a war or other purpose, hyper-inflation usually occurs. One unit of money in the current period is worth substantially less in a near future period. Creating money in this manner is not good for an economy.

A better way to create money is to use the banking system. In the United States, the banking system must keep reserves (amounts of money based on deposit levels at the Federal Reserve Bank in non-interest bearing accounts that can not be used for any other purpose) When a bank makes a loan to an individual or business, money is created. The money is created because the bank puts the proceeds of the loan into a checkable account for the borrower. This increases both sides of a banks balance sheet and "increases" the money supply. Since the lending bank must keep a required reserve, the full amount of the loan does not enter the money supply. The increase in the money supply is not limited to the lending bank. The reserve amount stays out. This ratio is controlled by the Federal Reserve System. The money that the borrower spends increases the checkable accounts of the sellers of goods that the borrower purchased with the loan proceeds. This process compounds the effect of the original banks loan. The actual amount of created money is reciprocal to the required reserve rate (M=1/r, where r = the reserve rate). Banks are able to continue to create money as long as they meet their reserve requirements.

Banks can create money by purchasing bonds from the public or government. Purchasing bonds adds checkable deposits to the sellers that can be used to purchase goods and/or services. The total effect on the money supply is comparable to the loan example above.

Monetary Policy

An economy can be affected by fiscal or monetary policy. Fiscal policy is enacted by the government through legislation and monetary policy is determined by economic policies enacted by the Federal Reserve System. Direct legislation by the government can be affected by political agendas and may not be implemented in an unbiased way that best benefits an economy. "Because monetary policy works more subtly, it is more politically palatable (McConnell, 2005, pg 305).

Monetary policy has two advantages over fiscal policy: 1) speed and flexibility and 2) isolation from political pressure. Monetary policy changes can be quickly enacted by the Federal Reserve System on a daily basis and there are many different methods available to accomplish the same goal. The governors of the Federal Reserve System are appointed for 12 year terms and are insulated from the normal political pressures (McConnell, 2005, pg 304).

Monetary policy does have limits and possible problems. There is difficulty in recognizing what is happening in the economy and this leads to timing issues in getting the actual policy changes made. Changes in the velocity of money (how many times in a certain period that the same money is used - a large turnover or a small turnover) can reduce the effectiveness of policy changes. Even though the policies are in effect to increase borrowing and spending during a recession, there is normally a reluctance of businesses and consumers to borrow and spend in this type of economic period.

Monetary policy is a process that is used to control the money supply of an economy. The "object of monetary policy is 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, people's and firm's willingness to spend on goods and services" (Federal Reserve Bank of San Francisco, 2004). Monetary policy is accomplished by maintaining, increasing or decreasing the money supply. The level of the money supply and the ease or difficulty of obtaining money directly affects the strength of an economy. Monetary policy works because the United States banking system is a fractional reserve system. A fractional reserve system requires banks to keep part (a percentage or fraction) of their money in the Federal Reserve Bank. This percentage of money can not be used for productive purposes.

The Federal Reserve affects the money supply by using three tools: 1- Open-market operations (the buying or selling securities - this will change checkable deposits by adding or removing money from the buyer/seller), 2- Reserve Ratio (lowering or raising banking reserve requirements - changes the amount of money available for making loans or purchasing securities by changing the amount of money a bank must "leave" at the Federal Reserve Bank) and 3- Discount Rate (the lowering or raising of the discount rate at the Fed Window - makes borrowing from the Federal Reserve more advantageous or less advantageous for a bank). The first option in each of the above parameters will increase the money supply and the latter will decrease the money supply.

Effect of Monetary Policy on Macroeconomic Factors

The macroeconomic factors are: gross domestic product, unemployment, inflation and interest rates. Monetary policy affects each of these factors in unique ways. Identifying the factor that one must change and properly adjusting monetary policy to affect the desired change is the challenge for monetary policy.

Gross domestic product (GDP) is a combination of personal consumption, investment,