Macroeconomic Impact on Business Operation

Macroeconomic Impact on Business Operation

Debra Alvarado-Rocha

MMPBL/501

May 7, 2011

Edward Hartmann

Macroeconomic Impact on Business Operation

The Federal Reserve utilizes a variety of tools to manage the economy. The Federal Reserve utilizes these tools to help form the monetary policy, which helps support the economy and reduces the inflation rate and employment rate. The Fed's can control the money supply by increasing or decreasing these tools. In this paper the subject to examine is what tools are used to control the money supply, the macroeconomic implications, how the money is created, and what combinations of the tools will help to achieve balance in the economy, have a low inflation rate, and a reasonable rate of unemployment.

Tools Used to Control the Money Supply

There are three main tools that the Federal Reserve uses to manage the money supply are open market operations, reserve ratio, discount rate. The Federal Reserve uses these tools to help shape the monetary policy, which helps to support the economy, the inflation rate and the unemployment rate.

The first tool is the open market operation is where banks and the public can buy and sell government bonds. "The open market operations are the most important tool that the Fed's can use to influence the money supply" (McConnell & Brue, 2005, p. 270). The Open Market Operations (OMO) uses Treasury bills, notes, and bonds. The different between the Treasury bills, notes, and bonds is the length of maturity. These will help to generate money, increase the Gross Domestic Product (GDP) and decrease the unemployment rate. The Federal Reserve also needs to watch the inflation because inflation is also a factor in the open market operations.

"When trying to decide-whether to change legal reserve ratios or to engage in open-market operations, do not simply get together and toss a coin" (Kareken, 1961, p. 1). Which brings us to the second tool reserve ratio, the reserves needs to keep a percentage of the banks deposit. "The Fed can also manipulate the reserve ratio in order to influence the ability of commercial banks to lend" (McConnell & Brue, 2005, p. 273). By raising and lowering the reserve ratio, the Fed's can control the amount the commercial banks can lend to the public.

The third tool is the discount rate, "the discount rate encourages commercial banks to obtain additional reveres by borrowing from the Federal Reserve Banks" (McConnell & Brue, 2005, p. 275). If there is an increase this will discourage the commercial banks from obtaining additional reserves, so the Fed's may raise the discount rate to restrict the money supply.

"According to Jensen, Mercer, and Johnson (1996), discount rate changes

are a good indicator of monetary policy because: (a) rate changes are perceived

to be exogenous signals of Fed actions that are easily interpreted by market

participants; (b) rate changes are widely reported and are made only at substantial intervals (there were only 150 rate changes in the 73 years in our sample); and (c)

rate changes are interpreted as signals confirming monetary and real output

developments" (Gangopadhyay, 2008, p. 77).

Macroeconomic Implications

"Macroeconomics examines either the economy as a whole or its basic subdivisions or aggregates, such as the government, household, and business sectors" (McConnell & Brue, 2005, p. 23). Economic measures include output, unemployment, income, and aggregate expenditures are addressed in the macroeconomics. Macroeconomics studies the economy as a whole. An increase in the GDP will increase the money demand, because of the decrease in unemployment and increase in inflation.

How Money is Created

Money is created in the economy and by the banks. The financial institutions are those who loan out the money to the people, and this in return creates money. The banks are the financial institutions that earn the money; this is the difference between the discount rate, which is the interest rate applied by the Fed's, and the banks charges the interest rates to the consumers.

One of most frequently tool used in creating money is the Open Market Operations (OMO). As mentioned above the Open Market Operation is