Macroeconomic Impact on Business Operations

In this paper, I will identify the three monetary tools used by the Federal Reserve. In addition, I will explain how these monetary tools influence the money supply and in turn affect macroeconomic factors. Next, I will explain how money is created. Lastly, I will recommend monetary policy combinations that best achieve a balance between economic growth, low inflation, and a reasonable rate of unemployment.

Tools Used by the Federal Reserve to Control the Money Supply

The three monetary tools used by the Federal Reserve to alter the reserves of commercial banks are: Open-market operations, reserve ratio, and the discount rate (McConnell-Brue, 2004, chpt. 15). The most powerful and flexible tool of the Federal Reserve is Open-market operations. Open-market operations occurs when the buying of government bonds from, or the selling of government bonds to, commercial banks and the general public (McConnell-Brue, 2004, chpt. 15).

The Federal Reserve can also influence the ability for commercial banks to lend by manipulating the reserve ratio. The reserve ratio is the amount the Federal Reserve is requiring the banks to keep in their reserve. By increasing or decreasing the reserve ratio, this determines if a bank has more or less money to lend (The Federal Reserve, 2007).

In the event that a main bank would have unexpected or immediate needs for additional funds, the Federal Reserve can make short-term loans (McConnell-Brue, 2004, chpt. 15). The discount rate is the rate of interest that the Federal Reserve charges to borrow money (The Federal Reserve, 2007).

Tools Used to Influence the Money Supply and Affect Macroeconomic Factors

When the Federal Reserve buys securities in the open market, commercial banks’ reserves are increased. This results in banks lending out their excess reserves which in turn will increase the supply of money. On the other hand, when the Federal Reserve sells securities in the open market to commercial banks or to the public, bank reserves will be reduced and thus the nation’s money supply will decline (McConnell-Brue, 2004, chpt. 15).

“The Fed can also manipulate the reserve ratio in order to influence the ability of commercial banks to lend” (McConnell-Brue, 2004, chpt. 15). If the Federal Reserve increases the reserve ratio, then this would increase the amount of required reserves a bank must keep on hand (McConnell-Brue, 2004, chpt. 15). Increasing the reserve ratio will cause banks to lose excess reserves and reduces the ability for the bank to create money through lending. On the other hand, “lowing the reserve ratio transforms required reserves into excess reserves and enhances the ability of banks to create new money by lending” (McConnell-Brue, 2004, chpt. 15). Changing the reserve ratio is infrequently used, although a powerful tool that can be used by the Federal Reserve (McConnell-Brue, 2004, chpt. 15).

In some immediate situations it may be necessary for banks to have unexpected or immediate needs for additional funds. For these cases, each Federal Reserve Bank will make short-term loans to commercial banks in its district. The Federal Reserve Bank sets the discount rate. Commercial banks will increase their reserves and enhance their ability to extend credit by borrowing from the Federal Reserve Banks (McConnell-Brue, 2004, chpt. 15). In the case when the discount rate is lowered, the money supply expands because banks are encouraged to borrow reserve dollars from the Federal Reserve (The Federal Reserve, 2007). On the other hand, if the Federal Reserve can restrict the money supply by increasing the discount rate since this will discourage commercial banks from borrowing from the Federal Reserve Banks (McConnell-Brue 2004, chpt. 15).

Explanation of How Money is Created

The United States has a fractional reserve banking system. The fractional reserve banking system is where only a fraction of the total money supply is held in reserve as currency (McConnell-Brue, 2004, chpt. 14). The history behind the fractional reserve banking systems began when early traders used gold to make their transactions. The traders found that not only was it inconvenient to carry gold and was also unsafe (McConnell-Brue, 2004, chpt. 14). The early traders began depositing their gold with goldsmiths and the goldsmiths would issue a receipt to the trader for their gold deposit. The goldsmiths came up with the idea that they could issue the paper receipts in excess of the amount of gold held and this was the beginning of the fractional reserve system of banking (McConnell-Brue, 2004, chpt. 14).

The two significant characteristics of fractional reserve banking are: 1) money creation and reserves; and 2) bank panics and regulation (McConnell-Brue, 2004 chpt. 14). Money is created by banks lending money. The most important source of money in the U.S. economy is the creation of checkable deposits, now that gold is no longer used as bank reserves (McConnell-Brue, 2004, chpt. 14). When loans are repaid, money is destroyed. Banks create new money when they buy government bonds from the public. The ability for a bank to create money will depend on the size of its excess reserves (McConnell-Brue, 2004, chpt. 14). Commercial banks have an obligation to keep required reserves that are equal to a percentage of their own checkable-deposit liabilities as cash or on deposit with the Federal Reserve Bank or their district (McConnell-Brue, 2004, chpt. 14).

Monetary Policy

The recommended monetary policy is a policy that best achieves a balance between economic growth, low inflation, and a reasonable rate of unemployment. Economic growth is a goal for any economy. The rise in real wages and income provide greater opportunities to individuals and families without sacrificing other opportunities and pleasures (McConnell-Brue, 2004, chpt. 15). Monetary policy has become the dominant component of U.S. national stabilization policy. “The main strengths of monetary policy are: a) speed and flexibility and b) political acceptability; its main weaknesses are (a) time lags, (b) the possibility that changes in velocity will offset it, and (c) potential ineffectiveness during severe recession” (McConnell-Brue, 2004, chpt. 15).

The strengths of monetary policy are also advantageous over fiscal policy. For example, congressional involvement may delay the implementation of fiscal policy for months. On the other hand, the Federal Reserve can buy or sell securities daily and can affect the money supply and interest rates immediately (McConnell-Brue, 2004, chpt.