Macroeconomic Impact On Business Operations

Macroeconomic Impact on Business Operations

The Federal Reserve System (the FED) is the Government agency that oversees and regulates the U.S.'s money supply. Its primary purpose is to balance the supply of cash and credit with the needs of the Nation's economy. The Fed consists of 12 Federal Reserve Banks and an eight member Board of Governors. (The Federal Reserve Bank of St. Louis [FRBSL], 2006, p. 5) The Board utilizes three tools to influence the money supply in the US, Open Market Operations, the Discount Rate, and Reserve Requirements. (McConnell & Brue, 2005, 242)These tools influence the amount of money created and distributed in the economy, create balance between economic growth, low inflation, and a reasonable rate of unemployment. This paper will attempt to demonstrate how money is made, the history of the FED, how the FED pulled the US out of the recession following the Stock Market bubble, and 9/11 attacks, and present criticism of the FEDS actions.

History of the FED

How Money was Made

US Banks previously utilized the fractional reserve banking system by the issuing of currency based on a portion of deposits in reserve in banks vaults. In the 19th century, banks created money by issuing receipts of gold deposited in a banks vault. These receipts were accepted currency, and banks would create money by loans based on a portion of gold reserves in the banks vaults. As long as only a small number of holders made withdrawals for gold, the bank could continue its daily operations. But, a bank panic would occur if the all holders of these receipts would demand gold at the same time because the bank did not have enough gold to cover the amount of receipts it had distributed (McConnell & Brue, 2005, p. 253). Banks are primarily a for-profit business and bank managers would often consider the needs of the bank rather than the economy or communities it served. This would often lead to an inappropriate amount of distributed currency which lead to rapid inflation or lack of growth in the economy. The lack of a centralized banking system produced a confusing and inconvenient number of bank notes. These factors lead to crippling bank panic in 1907 and the creation of the Federal Reserve System (FRBSL, 2006, p.6).

Congress Reacts

In 1913, Congress enacted The Federal Reserve Act in response to the frequent panics that plagued the Nation's fragile banking system (FRBSL, 2006, p. 6). This act created the Federal Reserve System. The Fed consists of 12 Federal Reserve Banks and an eight member Board of Governors. The FED was initially was to act as a centralized bank to deal with bank panics. However, through the last century, its role has grown to control fiscal policy and control the nation's money supply (McConnell & Brue, 2005, p. 242). The FED uses three tools to influence the money supply in the US including Open Market Operations, the Discount Rate, and Reserve Requirements.

Tools of the FED

Open Market Operations

Open Market Operations is the Federal Reserve's primary tool to implement monetary policy. The Federal Open Market Committee (FOMC) meets 8 times a year to present information of the state to the economy and predict what direction the economy is going. Armed with this information, the Committee decides wether it will buy or sell Government securities to tighten, ease, or maintain the Federal Funds Rate. The purchase or sale of these securities influences the Federal Funds Rate, by reducing or increasing that banks have on hand to lend to borrowers. If the Board wants to stimulate the economy, the Fed will buy the securities, which in turn will increase the cash in the Reserve Banks and reduce the Federal Fund Rate, allowing these banks to lend more money non Reserve Banks to make available to borrowers. If the Committee decides to slow the economy, they will sell government securities, to decrease cash in the Reserve Banks vaults and increasing the Federal Fund Rate, making less money available to lend (FRBSL, 2006, p. 7).

The Discount Rate

The Discount Rate is the interest rate that Reserve Banks charge for very short-term loans to large, healthy banking institutions. In the past its primary function was to maintain the day to day operations of large sound institutions for the sake of other institutions. The Discount Rate was very limited and regulated to prevent overuse, and for banks to exhaust other sources of funding before borrowing from the Reserve. Since 2003, The Discount Rates use is encouraged by offering funds at less than the Federal Funds rate and fewer restrictions on how these borrowed funds are used. By relaxing the rules, this encourages larger non Reserve Banks to offer loans at a more attractive rate, stimulating borrowing for increased economic growth (The Federal Reserve Bank of New York [FRBNY], 2006).

Reserve Requirements

The Board of Governors set Reserve Requirements, or the amount of funds an institution must have in reserve on hand or as a deposit in a Reserve Bank. The higher the requirement, the less cash is available for institutions to lend, increasing interest rates, and tightening requirements to borrow. The lower the requirement, more money is available to lend at a lower rate and lower requirements (FRBNY, 2006).

The Recession of 2000-2002

On Monday, March 29, 1999, the Dow Jones Industrial average closed over 10,000 (Dugan & O'Harrow, Jr., 1999) and the US economy saw continuous real GDP Growth since 1991(Norton & Harrington, 1999). Unemployment was at 4.2% (U.S. Department Of Labor Bureau of Labor Statistics [BLS], 1999, p. 1) and inflation was a low 2.7% (U.S. Department of Labor Bureau of Labor Statistics [BLS], 2007, 1). However, by October 2002, Dow was trading at 7,286.27, real GDP was a paltry 1.9% (US Department of the Treasury [USDT], 2006), unemployment was 5.7% (BLS, p.1), and the U.S. was still in mourning from the events of 9/11. The Fed, led by former chairperson Allen Greenspan, is credited for the U.S.'s economic prosperity through out the 1990's, sustained low inflation and for pulling the U.S. out of this recession following the Stock Market bubble and 9/11 terrorist attacks.

Open Market Operations

When the economy started to slow at the end of 2000, the FOMC began to target the Federal Funds Rate. From January 2001 through March 2001 the Federal Funds Rate was dropped from 6.00% to 5.00%. (The Federal Reserve Bank of New York [FRBNY],