Macroeconomic Impact on Business Operations

There are three main tools the Federal Reserve can utilize to control the US money supply. These three major tools are: reserve requirements, discount rate, and open market operations. The US economy, which is influenced by national interest rates, inflation variability, and unemployment rates, these areas also have an effect on the overall economic growth of the country, are all significantly influenced by the monetary policies in operation by the Federal Reserve. In addition to these factors influenced by the Federal Reserve, the Central Bank can also offset and influence the US economy with the process of money creation. This paper will identify and analyze the tools used by the Federal Reserve to control monetary policy, and how this, in turn influences the US economy and money supply.

The first of the three major tools employed by the Federal Reserve is known as reserve requirements. Reserve requirements can be defined as: "The ratio of reserves (vault cash plus deposits at a Fed bank) to transactions deposits that commercial banks must keep on hand." (Dakota State University, 2003) These reserves are held for specified deposit liabilities by federally insured banking institutions. Reserve limitations are specified by law, and under the sole authority of the Board of Governors. (The Federal Reserve Board [FRB], 2006) While the Board of Governors has sole authority over the reserve requirements, manipulation to this policy is fairly infrequent, once every 5 to 10 years on average. (Johnson, 2005, para. 13)

The second tool used by the Federal Reserve to control money supply is known as the discount rate (DR).

The discount rate is the interest rate charged to commercial banks and other depository institutions on loans they receive from their regional Federal Reserve Bank's lending facility... Discount rates are established by each Reserve Bank's board of directors, subject to the review and determination of the Board of Governors of the Federal Reserve System. (Federal Reserve Board [FRB], 2006)

While the Board of Governors holds final authority on the DR, the suggestion of each of the 12 Reserve Banks can influence the final decision on the DR. The DR is changed on average once or twice a year. (Johnson, 2005, para. 13)

As the discount rate (DR) rises, it becomes more expensive for banks and other financial institutions to borrow from the Federal Reserve Bank; due to this the money supply decreases. Oppositely, when the DR decreases, more banks can borrow, and the amount of loans processed will increase. The money supply will therefore, increase. "A review of the evidence over the past 20 years clearly reveals that the Reserve Banks interpret their discount rate responsibilities differently... [Reserve Banks] attach differing importance to the policy goals, and they seem to use different information sets or "models" in determining how best to reach those goals." (McNees, 1993)

The third and most commonly used tool of the Federal Reserve to influence money supply and monetary policy is Open Market Operations (OMO).

The purchase or sale of U.S. Government securities in the "open market"--also known as the secondary market--is the Federal Reserve's most flexible means of carrying out its objectives. By adjusting the level of reserves in the banking system through open market operations, the Fed can offset or support seasonal or cyclical shifts of funds and thereby affect short-term interest rates and the growth of the money supply. (Federal Reserve Bank of New York [FRBNY], n.d.)

"In the early 1920s, the Federal Reserve began to see open market operations as an effective tool with which it could and should control the aggregate quantity of credit." (Small & Clouse, 2005, 15) According to The Federal Reserve Bank of Minneapolis, The Federal Open Market Committee (FOMC) "is the most important monetary policymaking body of the Federal Reserve System. It is responsible for the formulation of a policy designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments." (Federal Reserve Bank of Minneapolis [FRBM], n.d.) Open market operations directly affect the amount of available reserves in the banking system. Federal Reserve purchases of securities add to reserves; sales withdraw reserves from the System. (Federal Reserve Bank of Minneapolis [FRBM], n.d.)

Money creation is the process by which the Federal Reserve offsets a deficit by creating new money. "Federal spending can increase without adversely affecting investment or consumption. The creation of new money is more expansionary (but potentially more inflationary) than borrowing as a way of financing deficit spending." (McConnell & Brue, 2004, ch. 12, 17) Money can also be created by banks through lending. "the creation of checkable deposit money by banks (via their lending) is limited by the amount of currency reserves that the banks feel obligated, or are required by law, to keep." (McConnell & Brue, ch. 14, 5) This form of money creation although not controlled, is limited by the Federal Reserve and the reserve requirements placed upon financial institutions. Smaller amounts of reserves required by the Federal Reserve allows for more money that can be created through lending by private banks and financial institutions.

The three main tools of the Federal Reserve to influence money supply can also be offset by one remaining factor not controlled by the Federal Reserve. In addition to changes to the reserve rate, discount rate, and open market transactions, individuals can affect the money supply through changes in the amount of cash held outside of banking institutions. The one way the Federal Reserve can influence this factor of the money supply, is by increasing the public's confidence in the banking system. "In the Great Depression, one of the real problems was people lost confidence in the banks and took their cash out of the banks, a pattern that caused the money supply to decrease. When people want cash, the reserves in the banks fall which creates a bigger drop in demand deposits. The result is a net decrease in the money supply." (University of Rhode Island [URI], n.d.)

Using its discretionary power to manipulate these policy tools, the Fed is able to exercise substantial influence (but not complete control) over changes in the size of the money stock and thus over interest rates, thereby influencing overall levels of business activity and employment in the national economy (as well as indirectly influencing the rates at which the dollar is exchanged for foreign currencies and thus the flow of international trade and investment across U.S. borders). (Johnson, 2005,