Macroeconomics Impact on Business Operations

Macroeconomics Impact on Business Operations

Macroeconomics seeks to obtain a general outline of the structure of the economy and the relationships of its major aggregates and factors such as the GDP, unemployment, inflation, and interest rates affect the economy. The most important factor is the process of creating money, and this is not dealing with the printing of the paper and coins. The Federal Reserve also known as the Fed use reserve requirements, discount rates, and open market operations as tools to control the money supply. One must also understand how the Federal Reserve (Fed) combines monetary policy to help create a balance between economic growth, low inflation, and a reasonable rate of unemployment.

How Money Is Created

According to the Dictionary.com (2011) website the definition of money is any circulating medium of exchange such as coins, paper money, gold, silver, or demand deposits issued as a medium of exchange and measure of value. Most people think of money as the cash one can deposit, withdraw, or borrow down at the local bank, but it is much more complex than that and yet simple at the same time. What a bank does is to loan an amount of money to an individual by writing it into a borrowers account based on the promise to pay. A person or business will agree to pay the money loaned, including interest, and if they fail to pay it back will forfeit some sort of collateral such as a car, home, or property. A basic example of how a bank in the United States can create money is as follows. In an example given by The Big Picture (2009) website is a bank has a reserve deposit of $1,111.12 in cash money, they are allowed lend out $10,000. They can loan out this amount because the reserve ratio in the United States is 9:1, or the bank's reserve can legally conjure into existence nine times the amount of money it has in its reserve, thus $1,111.12 = $10,000. The bank credits the money to the account of the borrower who can write a check against the amount to purchase goods or services. The receiver of the $10,000 will deposit the money into a commercial bank and in turn the bank can loan that money out at a 9:1 ratio. So of the money deposited the bank can loan out $9,000 and must keep $1,000 in reserve. The process is repeated multiple times and could potentially create hundreds of thousands of dollars within the banking system. In the simplest of terms money is loaned into existence.

Tools Used By the Fed to Control Money Supply

Three basic tools the Fed uses to control the money supply are reserve requirements, discount rates, and open market operations. One way the Fed uses to control the amount of money is to change the reserve requirements of banks. This is a tool rarely used because even the smallest change can cause a drastic effect on the economy so it is only uses under extreme conditions. The Options A to Z (2011) website stated this was a tool used in the early 20th century to guard against speculative movement in the stock market. According to Options A to Z (2011), "they would raise requirements when the market was strong, and lower it when the market trended sideways or downward" (How Does the Fed Control the Money Supply?, para. 11). The requirement has changed 22 times between 1934 and 1974, but since has been kept at a constant 50% since 1974.

A second tool the Fed uses to control the money supply is changing the discount rate. When banks borrow money from the Fed, the loan is called borrowing from the discount window, and the interest rate the bank will pay is the discount rate. Banks will turn over assets at a discount basis to the Fed in exchange for cash and the interest rate has an effect on the banks interest on loans to customers. If the bank pays a high discount rate, it is more expensive for the bank to borrow money and loans to the public become more expensive. If the discount rate is lower the banks are more likely to borrow, creating more reserve for the bank, and this causes lower interest rates for the public. Options A to Z (2011) states, "if the Fed raises and lowers the discount rate, banks know they are changing monetary policy and usually raise or lower their rates accordingly" (How Does the Fed Control the Money Supply? para. 21).

The third tool the Fed uses is open market operations. The Fed will use this tool daily to fine-tune the rates by buying and selling government bonds in the open market. The Fed will use this tool to control the money supply and affect its value as well as control the interest rates. A simple way to explain it is if the Fed buys bonds money supply increases and interest rates fall. If the Fed sells bonds money supply decreases and interest rates rise. So the Fed can control the money supply by using the reserve requirements, adjust the discount rates,

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