Macroeconomic Impact on Business Operations

Mediums of exchange have been used by people for many years. As time evolved so did the creation and use of money. Different countries have their unique dominations; however, how money is created is essentially the same. Often, money is thought to be created when it is printed by a central bank or the government. This is only partially true as money can be created in two ways; it can be printed or it can be created through loans from commercial banks. With the creation of money, policies have to be implemented to monitor and control the supply. If too much money is in circulation inflation is possible, and if too little money is in circulation a recession is possible. This paper will discuss how money is created, the effects of monetary policies on the supply of money and how monetary policies affect the macroeconomic factors of the economy.

The most modern way of creating money is through loans. Commercial banks are required by the Federal Reserve to keep a required reserve that is “an amount of funds equal to a specified percentage of the bank’s own deposit liabilities” (McConnell & Brue, 2002, p. 254). Once the reserve is met, banks can add extra reserves to the Federal Reserve Banks which will enable the commercial banks to lend money. When a loan is made to a customer, funds are transferred to borrowers through checkable deposits. The loan creates an asset on one side of the bank's balance sheet and a liability on the other side (the checkable deposit). As the borrower uses the new loan, the checkable deposit, to make purchases money is created because addition checkable deposits will be created in other banks.

Real-world complications can arise from this money creation model. The Federal Reserve does not constrain the banks ability to increase its reserve as, “reserves can be borrowed overnight in the Fed funds market at a rate that changes little from day to day” (Federal Reserve Bank of Atlanta, 1993). In the short run, a bank’s reserve requirements do not pose a barrier to the bank’s ability to increase the money supply. A second complication that may arise is the possibility that a borrower may want a part of his or her loan in currency not in a checkable deposit. Any currency that remains in circulation decreases the excess reserves of the banks which would decrease its leading potential.

The economy functions in a cyclical way with recessions and expansions. When there is an expansion, banks will not hesitate to lend money as “loans are interest-earning assets, and in good economic times there is little to fear of borrowers defaulting” (McConnell & Brue, 2004, p. 264). When the economy is in a recession banks may be unwilling to issue loans as they doubt the ability of borrowers to repay. To promote economic stability, monetary and/or fiscal policies can be used to control the supply of money. The Federal Reserve is the regulatory body that implements monetary policy; this policy can be implemented in three ways.

The first tool the Fed uses is open market operations to buy or sell government bonds to commercial banks and the public. Buying bonds from commercial banks will increase the bank’s reserves. An increase in the bank’s reserve will increase the ability of the bank to issue more loans which will lead to more money creation. Buying bonds from the public has the same effect. Payment that is received from the Federal Reserve will be deposited into the commercial banks that will cause an increase in the bank’s reserves and the checkable deposits. Selling bonds will have the opposite effect on the money supply. When securities are sold to commercial banks, these commercial banks will pay for these bonds by drawing checks against their deposits. When the Fed collects these checks, it will in turn lower the reserve of the banks. This will lead to a reduction in the ability of the commercial banks to make loans. Securities that are sold to the public will also have the same effect on the money supply as the public will pay for these bonds with checks that will be drawn against the bank.

The second policy the Fed can use to influence the money supply is by manipulating the reserve ratio. The reserve ratio influences “the ability of commercial banks to lend” (McConnell & Brue, 2004, p.273). If the Fed decides to raise the reserve ratio, the excess reserves that banks have will decrease. The excess reserves decrease because banks are now required to have more money in their reserve ratios. “As a consequence, either banks lose excess reserves, diminishing their ability to create money by lending, or find their reserves deficient and are forced to contract checkable deposits and therefore the money supply” (McConnell & Brue, 2004, p.273-274). The opposite will happen if the Fed lowers the reserve ratio. Banks would now have more opportunity to lend money as their excess reserves would increase. “Lowering