Macroeconomics

"Macroeconomics is a branch of economics that deals with the performance, structure, and behavior of a national economy as a whole. Macroeconomists seek to understand the determinants of aggregate trends in an economy with particular focus on national income, unemployment, inflation, investment, and international trade" (Wikipedia, 2007). Government tends to use a combination of both monetary and fiscal options when setting policies that deal with the Macroeconomic.

According to McConnell & Brue (2004), governments make adjustments through policy changes which they hope will succeed in stabilizing the economy. Governments believe that the success of these adjustments is necessary to maintain stability and continue growth. The stabilization of the economy requires (1) Appropriate fiscal policy which consists of deliberate changes in government spending tax collections designed to achieve full employment, control inflation, and encourage economic growth. (2) Intelligent management of regulation of the money supply (monetary policy). This paper is primarily focus on the monetary system in Macroeconomic and the paper will identified the tools that used by the Federal Reserve to control the money supply, Macroeconomic Factors, and the monetary policy combinations that best achieve a balance between economic growth, low inflation, and a reasonable rate of unemployment.

How money is created and what is the Money Supply?

According to Schwartz (2002), the definition of money has varied, most commonly silver or gold, served as money. Later when paper money and checkable deposits were introduced, they were convertible into commodity money. The abandonment of convertibility of money into a commodity since August 15, 1971, when President Nixon discontinued converting U.S. dollars into gold at $35 per ounce, has made the U.S. and other countries' monies into fiat money-money that national monetary authorities have the power to issue without legal constraints.

Money is used in all economic operations; money has a powerful effect every economic activity. The increase in supply of money put more money in the hands of the consumers and increased spending. When the money supply continues to expand and the prices begin to increase, particularly if the output growth reach to the capacity limits as the public begin to expect the inflation, lenders insist on higher interest rates to offset and expected decline in purchasing power over the life of their loans. Contradictory results happen when the supply of money falls, or when the rate of growth cries off. The U.S. money supply comprises currency-dollar bills and coins issued by the Federal Reserve System and the Treasury-and various kinds of deposits held by the public at commercial banks and other depository institutions such as savings and loans and credit unions. On June 30, 1990, the money supply, measured as the sum of currency and checking account deposits, totaled $809 billion. Including some types of savings deposits, the money supply totaled $3,272 billion. And even broader measure totaled $4,066 billion (Schwartz, 2002).

These determinants are corresponding with three definitions of money that the Feral Reserve uses for the "official" definitions of the money supply. M1 consists of currency and checkable deposits; M2 consists of M1 plus savings deposits, including money market deposit account, small (less than $100,000) time deposits, and money market mutual fund balances; and M3 consists of M2 plus large ($100,000 or more) time deposits. The major functions of the Federal Reserve are to (a) issue Federal Reserve notes, (b) set reserve requirements and hold reserves deposited by banks and thrifts, (c) lend money to banks and thrifts, (d) provide for the rapid collection of checks, (e) act as the fiscal agent for the Federal Government, (f) supervise the operations of the banks, and (g) regulate the supply of money in the best interest of the economy (McConnell & Brue 2004).

Tools used by the Federal Reserve to Control Money Supply

The demand for money does not only verify the rate of interest but as well of the prices and national income of the economy. As mention on the introduction that Macroeconomic focus on national income, unemployment, inflation, investment, and international trade. In order to lead to these goals, the extreme increases in the money supply will lead to high inflation and the demand for money with the supply of money effect to the interest rates. To prevent the problem, the government needs to control the money supply in order to accomplish the goals. The Federal Reserve can control the money supply through three mechanisms: (1) setting the Federal Funds Rate; by decreasing the interest rates and effectively making money less expensive to borrow, the Federal Reserve increases the demand for money, (2) Open-Market Operations (buying U.S. Government Treasuries); when the Federal Reserve purchases U.S. Treasuries it loans money to the U.S. government. In addition to the money created by the Fed to purchase these treasuries, the assets of the Federal Reserve increase allowing them to lend more to their clients under the fractional reserve backing system, and (3) Adjusting the Reserve Ratios; all banks operate under a fractional reserve banking system whereby they must legally hold a set amount of cash reserves against the amount they lend out to their customers. By adjusting the reserve ratio limits, the Federal Reserve can affect the amount of money commercial banks are able to lend. Increasing these ratios, deflates the money supply because banks can no longer lend out as much before. Decreasing them has the opposite effect (Hewitt, 2007).

Money supply has a tendency to increase fast throughout business cycle extensions than the period of business cycle reductions. The rate of increase is likely to decelerate before it hits the highest point in business and to expedite before drain.

How tools influence the Money Supply and Macroeconomic factors?

Interest rate is one of the tools that Federal Reserve used to control the Money Supply. Interest rate influences the money supply and macroeconomic factors. Interest rate is the fee from borrowing money. To explain this influence and how, when Federal Reserve set the discount rate, as well as achieves the desired Federal Funds rates by open market operations. The rate has significant effect on other market interest rates. Because changes interest rate are done in response to various market indicators in an attempt to forecast economic trends and in so doing keep the market on track towards achieving the defined inflation target. If money supply goes up, that means the easier to borrow