Macroeconomical Impact on Business Operations

Monetary policy plays an important role in today's economy. The role of monetary policy is to strike a balance among the key macroeconomic variables in the changing times of today. The importance of this paper is to learn how monetary policy affects our money supply and what tools the Federal Reserve uses to control the money supply. One will also learn how the changes in the tools that the Federal Reserve uses affect the GDP, inflation rate, unemployment, and interest rates. The most appropriate monetary polices that the Federal Reserve uses to help control the economy are also discussed.

The supply of money consists of Federal Reserve notes, coins, and checkable deposits. Money supply is created by the U.S. Bureau of Engraving, which produces the Federal Reserve notes, U.S. Mint, which produces coins, and banks, thrifts, and loan officers who create checkable deposits. Checkable deposits make up more than half of the nation's money supply. They are created by the purchase of government bonds from the public and the issuance of loans. The banks limit the creation of checkable deposits by the amount of currency reserves that they feel obligated, or required by law, to keep. Although people might think there should be an investigation with the banks, thrifts, and loan officers for creating checkable deposits, the Federal Reserve relies on these institutions to create such an important component of the nation's money supply (McConnell & Brue, 2004)

Four tools exist that the Federal Reserve uses to control the money supply. Those tools consist of the federal funds rate (FFR), discount rate (DR), required reserve ratio (RRR), and the volume of open market operations (OMO). These same tools, along with complex analyses, are used to control the real GDP, inflation, and unemployment levels. Whenever a response to global economic phenomena occurs, fluctuations in the behavior of the economy will follow (University of Phoenix, 2002).

When the DR decreases, the spread between the DR and the FFR becomes greater. At this point, banks will shift their place of borrowing from other banks to the Federal Reserve, which results in an increase of the total amount of money in the system. When the DR is above the FFR, the spread between the two will be positive and banks will then borrow from other banks. Banks borrowing from one another has no effect on the supply of money (University of Phoenix, 2002).

The RRR is federally mandated and is the percentage of deposits that banks hold as reserves, either in vaults or with the federal government. If this ratio declines, banks are required to hold a lesser amount as reserve. Banks can also lend that much more to customers, which results in a increase of the money supply in the economy. When RRR rises, the money supply decreases, thereby causing banks to drain the system (McConnell & Brue, 2005, ch. 14).

The OMO are composed of T-bills, bonds, and other federal instruments. Investors will usually buy and sell OMO through auctions. Money is drained out of the system when investors sale T-bills, bonds, and other federal instruments. Similarly, when these instruments are bought, money is released into the system (University of Phoenix, 2002).

In the changing times of today, it is important to keep a fine balance between the key macroeconomic variables, such as GDP, unemployment, inflation, and interest rates. Complex analyses are done to determine appropriate combinations of monetary policy that would best achieve the balance that our economic environment requires (University of Phoenix, 2002). To determine an appropriate combination of monetary policies to use, one must first understand the effects that monetary policies have on the key macroeconomic variables.

Expansionary monetary policies are usually set in place when economic growth is sluggish and unemployment rates are high. In theory, these policies can increase consumer confidence, stimulate production activities and raise employment levels. When the Federal Reserve System adopted expansionary monetary policies in 2001, the FFR dropped to its lowest that the United States had seen in over 40 years. With a low FFR, borrowing costs are decreased and investment expenditures are increased, which then increases the total GDP. Since prices of goods do not respond immediately, it is prudent that the expansionary monetary policies are maintained for a sufficient duration that will "allow the lagged changes in price levels to be realized." As long as these policies are maintained, interest rates will drop further, the GDP will continue to increase, which will positively affect most industries in the U.S. economy (Kim, Goodman, and Kozar, 2006).

The expansionary monetary policies can also have different effects with different levels of competition. For example, in the banking industry, under perfect competition, an expansionary monetary policy can lower interest rates to spawn an increase in lending. Under a monopoly, interest rates on loans rise as growth rates get higher. As the degree of banking competition increases, a stronger impact can be made on an economy with high inflation rates. However, the expansionary monetary policy can weaken "the impact of productivity improvements in the transactions services market." (Laosuthi, 2007).

In a labor market with a diverse group of employees, a contractionary monetary policy can produce a positive shock to the FFR, which causes a decline in the inflation rate, real GDP, and skill premium. After a contractionary monetary policy takes place, the less educated will feel the brunt of the increased unemployment, but the gap between their wage and that of the higher educated gets closer (Khalifa, 2007).

The best time to undertake a contractionary monetary policy is when the economy is already growing at a rapid pace. This will help proactively control inflation even if the inflationary pressures are supply induced. Managing