Macroeconomic Impact

Macroeconomic Impact on

Business Operations

To control the supply of money in the United States the Federal Reserve uses three tools. The tools The Fed implements are Open Market Operations, The Reserve Ratio, and the Discount Rate. The three tools of monetary control each have distinct uses. This paper will define what the tools are, discuss how the three tools influence the money supply and macroeconomic factors, and a recommendation for monetary policy combinations that best achieve a balance between economic growth, low inflation, and a reasonable rate of unemployment.

Open Market Operations is defined as "The Fed's open-market operations consist of the buying of government bonds from, or the selling of government bonds to, commercial banks and the general public. Open-market operations are the Fed's most important instrument for influencing the money supply". (McConnell, Brue 2004.) Purchases and sales of U.S. Treasury and federal agency securities are the Federal Reserve's principal tool for implementing monetary policy. An example of this would be when the Federal Reserve Bank procures securities on the open market, it increases the reserves of commercial banking making it possible for the banks to expand their loans and investments, thus increasing the flow of federal reserve notes. When the Federal Reserves buy six million dollars worth of bonds from commercial banks the reserves for the commercial banks swell to that amount.

Reserve Ratio is defined as "The ratio of the required reserves the commercial bank must keep to the bank's own outstanding checkable-deposit liabilities". (McConnell, Brue 2004.) The reserve ratio is another tool used in monetary policy impacting the country's economy, lending, and interest rates. When the Fed's raise the reserve ratio one of two things happens. The first possibility is that the banks lose excess reserves weakening their capacity to produce currency. The second possibility is that they find their reserves exiguous and are forced to commission checkable deposits thus tapping into the money supply.

Lowering the reserve ratio, required reserves would decline and excess reserves would increase. The bank's lending ability would increase. The banking scheme's money creating potential would broaden. "Lowering the reserve ratio transforms required reserves into excess reserves and enhances the ability of banks to create new money by lending. Although changing the reserve ratio is a powerful technique of monetary control, it is infrequently used. The last such change was in 1992, when the Fed lowered the reserve ratio from 12 percent to 10 percent". (McConnell, Brue 2004.)

The discount rate is defined as the interest on loans the Federal Reserve Banks charge commercial banks. (McConnell, Brue 2004.) The Fed does not encourage banks to borrow on a regular basis. Banks are advised to borrow for occasional, short term emergencies. Changes in the discount rate can affect Lending rates by making it either more or less expensive for banks to get money to lend or hold in reserve. Higher discount rates indicate that more restrictive monetary policies are in store, while a lower rate might signal a less restrictive move. "In short, borrowing from the Federal Reserve Banks by commercial banks increases the reserves of the commercial banks and enhances their ability to extend credit". (McConnell, Brue 2004.).

Money is created in a series of events. "Banks create money through lending." (McConnell, Brue 2004.). The creation of money, like many other things in existence came out of necessity. In the 1600's early American settlers found carrying gold coins, and having those coins appraised for purity for every business deal that they are engaged in to be annoying. The traders began to give their coins to goldsmiths. The goldsmiths would take the lump sum of coins and issue a receipt for the calculated amount. The traders would then present the receipt when involved in a business transaction. The use of paper receipts when making purchases was the first form of paper money.

The history of paper money is reflected in the following statement by McConnell and Brue (2004):

This was the beginning of the fractional reserve system of banking, in which reserves in bank vaults are a fraction of the total money supply. If, for example, the goldsmith issued $1 million in receipts for actual gold in storage and another $1 million in receipts as loans, then the total value of paper money in circulation would be $2 million twice the value of the gold. Gold reserves would be a fraction (one-half) of outstanding paper money.

The money used in our economy is formed and created by commercial banks and the credit they issue. When commercial banks purchase government bonds from the public what springs from that is what is considered lending, because new money is created. Money is born when financial institutions provide loans to candidates. The opposite is true when those loans are repaid, money disappears. The cycle repeats when the banks buy bonds from the community, and again, money leaves the scene when the banks sell government bonds to the public. In order for system of creating currency to exist the all parties involved believe that banks will make loans that households and businesses will borrow. "In reality, the willingness of banks to lend on the basis of excess reserves varies cyclically, and therein lies the rationale for government control of the money supply to promote economic stability". (McConnell, Brue 2004.)

During periods when the economy is at its best banks have little problems lending