American History

Macroeconomic Impact on Business Operations

Ronald R. Navalta

University of Phoenix

MBA 501

David Francom

September 3, 2007

Introduction

Money Supply

Money supply is the availability of money in the hands of the public (economy) that can be used to purchase goods, services and securities. In macroeconomics, the price of money is equivalent to the rate of interest. There's an inverse relationship between money supply and interest rates. As money supply increases, interest will decrease. On the other hand, interest will increases as money supply decreases. It is very important to understand that the economy works at market equilibrium. There are several factors affecting money supply; and these contributing factors will be the main focus of this paper. Understanding the basic principle on money supply is imperative to have a good grasp on the macroeconomic impact of money supply on business operations.

The Scenario/Simulation

Here's the scenario: "Recent global developments have pushed the economy into a slump. Industrial production is sluggish and it has become difficult to stimulate demand. The Real GDP is slipping and though inflation looks to be under control, unemployment seems to be soaring. As the Chairman of the Federal Reserve appointed by the President of Oval Office, an effective control of the money supply has to be done.

Tools that Control Money Supply

The Federal Reserve use several tools like discount rate, federal funds rate, required reserve ratio and open market operations to control the money supply. In the simulation, the effect of controlling the money supply on the economy was presented. Typically, releasing money into the system results in higher Real GDP and lower unemployment. On the other hand, it also raises inflation.

Inflation and Real GDP work cross-purposes. As stated in the simulation, "striking the right balance between the two is very critical". In addition, "compounding this with the effects of domestic policies and international happenings, and macro-economic system will almost become unpredictable". Money-Multiplier is another thing that is unpredictable. This determines whether the base money that the Fed will release should decrease or increase. As stated in the simulation, the Fed also "tries to use the money supply as a lever to keep the economy on the rails". This is not an easy task for it requires very complicated analysis.

Influence on Money Supply

There are several factors affecting the money supply: spread between the discount rate and federal funds rate, required reserve ratio and open market operations. It is very important to understand that whenever the "DR charged by Fed is lower than the FFR charge by other banks; banks tend to borrow from the Fed. If DR decreased, banks tend to borrow from other banks to the Fed. This will result to an increase in the total amount of money supply. Further, it is very essential to understand the spread between the DR and FFR. A positive spread (DR > FFR) prompts banks to borrow from another banks. This will not result into any changes in the money supply.

As defined in the simulation, "Required Reserve Ratio is the percentage of deposits that any bank holds as reserves". It is essential for businesses to understand that a decrease in RRR interprets a lesser bank reserves. Whenever RRR is low, banks can lend more; thus, increasing the money supply in the economy. On the other hand, an increase in RRR will decrease the money supply in the economy.

Open market operation is another thing that influences the money supply. It includes bonds, T- bills, and other investment tools. Sale of these investment tools decreases the money supply in the economy and buying these releases money.

Effect on Macroeconomic Factors

How money supply does affect the macro-economic factors? Why do businesses, leaders, economists and the like need understand the principles on money supply? The principles explained will provide indicators that are helpful in the decision making process. There are three macro-economic indicators: real gross domestic product (Real GDP), inflation rate and employment rate.

An increase in real GDP will increase the money supply. If there's more money in the system, there will be more investors; and this increase in investors will eventually lead to an increase in real GDP.

Another thing is inflation rate. Just like real GDP, an increase in money supply will also lead into an increase in inflation rate. Investopedia defines inflation as "the overall general upward movement of goods and services in the economy which is usually measured by the consumer price index and the producer price index". In the simulation, it is stated that "when the amount of money in the system is increased, the nominal value of money remains the same, but, as more money chases the same quantity of goods and services, the value of money is decreased". This will eventually lead to an increase in price which represents an increase in inflation rate.

Money supply also has an impact on unemployment rate; it is inversely related to Real GDP. As investment spending increases, there will be an increase in employment needs. The fact that there will be a need for an increase in production basically means that there will be a need for an increase in the labor force. This will eventually lead to a decrease in unemployment rate. Further, money supply in the system will decrease; thus, a decreased in Real GDP will eventually follow.

Creating Money

Money is a socially accepted medium of exchange for goods and services. It provides measurement of value and could be used as a measure of a nation's economic status. In the United States, the Federal Reserve is the one controlling the money supply in the economy. According to David Laidler, the creation of money is basically influenced by an economic theory called "monetarism". Laidler further explains that the management of money supply should be the primary means of regulating economic stability. With that said, there are several considerations in the creation of money. Money supply have a great impact