Macroeconomic Impact on Business Operations

Macroeconomic Impact on Business Operations

1a) the main tool used by the Federal Reserve to control money supply is interest rates. The main rate the Fed changes is the overnight bank rate, also known as the federal funds rate. This either lowers or raises the cost of money to banks. A lowering of the rate increases the profit margin on a new loan, which encourages banks to lend more money, thus putting it into the economy. A raising of the rate discourages lending, tightening the money supply.

The Fed also controls money supply through what is known as open market operations. This involves the purchase of U.S. government securities from financial institutions. The Fed essentially creates a credit on the bank's balance sheet to pay for these securities. This gives the bank new liquid reserves, which it can then lend out.

The third way in which the Fed controls money supply is through fractional reserve requirements. The reserve is a portion of each deposit that is held back. The remainder is what the bank is allowed to lend. Thus, a change in the fractional reserve requirement increases or decreases the amount of total deposits that the bank is allowed to lend. Because banks lend to other banks, the amount that is allowed to be lent is multiplied fivefold.

1b) Interest rates do not create money per se, they merely stimulate either investment or savings in the marketplace. This impacts directly the amount of money that is being invested back into the economy. The reason for this is that money not spent - in other words money that is being saved - is money that is not being put to a productive economy purpose. Naturally, a certain amount of savings is healthy for an economy because the ideal situation is that a society's consumers and corporations are in sound fiscal shape. However, savings do not stimulate growth, spending does.

On a macroeconomic level, this is reflected in the federal funds rate, which impacts interbank lending. When the federal funds rate increases, the spread between the cost of money for banks and the amount they charge their customers to borrow increases. This encourages lending, which in turn puts more money into the economy. When the federal funds rate decreases, the spread for banks does as well, discouraging them from putting more money into the economy.

Whereas the federal funds rate affects the likelihood of banks to lend out existing money, open market operations create new money. They increase the liquid reserves of banks, so that the banks have more money to lend.

Reserve requirements also affect the amount of money that banks can lend, but rather than dealing with new money, they affect the amount of existing money that is legally available for lending.

Once money enters the marketplace, it impacts every macroeconomic factor. It affects unemployment in that if the economy is recording growth, then investments can be made into expansion and diversification. This in turn creates jobs. The economy is unlikely to grow in an environment when savings rates are high, so in such situations fewer jobs are created, putting upward pressure on unemployment rates.

Inflation is also impacted by money supply. If growth becomes overheated, that is to say the economy grows at a rate where demand outstrips the ability of the economy to provide supply, then an inflationary environment is created. This drives price increases that in turn stifle growth, because the value of money is diminished. The Fed uses the money supply to keep inflation in check - if inflation starts to set in, rates are increased thereby discouraging investment. The net result either way is that for a time investment is discouraged, but the difference is that the Fed maintains control over this key macroeconomic factor. Inflation can get out of control, and when this happens there is a risk of catastrophic damage to the economy, even total collapse. But if the Fed has control over inflation, this will not happen. Moreover, the economy can be stimulated if need be simply by lowering rates again.

The GDP is also affected. When money enters the economy, it is used to purchase goods and services, increasing the GDP. When the money supply is tightened, the GDP can drop, because money is effectively being taken out of the economy. GDP increases and decreases multiply as well. If new money is used to purchase a good or service, the seller then has more money, and uses that money to make purchases of his own. Likewise this cycle of purchases can be broken with a tightening of the money supply, having a negative impact on the GDP.

Unemployment is affected as well. As money supply is loosened, businesses are encouraged to expand. Capital is more readily available to finance expansion, and a growing GDP further encourages this expansion by providing more money in the market to purchase the new goods or services that the expansion creates. Some of this investment will generate new jobs, lowering unemployment. Conversely, a tightening of the money supply will discourage the creation of new jobs.

2a) Money is created in three ways. First, open-market operations create money. When the Fed buys securities from the banks, it does not pay for them. Instead, it creates a credit on the balance sheet. This credit then enters the economy when the bank subsequently lends it. Open market operations are conducted with the objective of influencing the federal funds rate.

Essentially, the Federal Reserve either purchases or sells U.S. government securities. These transactions are conducted on the open market in a competitive environment, hence the term "open-market operations."

These securities can be issued by the U.S. Treasury, Federal agencies and government-sponsored enterprises.

A second way the Fed can create money is simply by printing more. This tool is not commonly used to influence monetary policy, as the amount of physical money is only a small proportion of total money supply. Printed money supply is generally based more on the demand for the physical version of money than the need to create more money in the economy. Based on this demand, the Fed either issues currency to the banks or takes in currency from the banks.

2b) One of the Fed's main roles is to achieve price stability. This is because inflation reduces the value of money, which in turn has a negative impact on the economy. The need to keep inflation in check must be balanced against the need to encourage economic growth, which in turn provides a reasonable level of unemployment. The goal of the Fed is to strike a balance between these factors. If the money supply is loosened too much, inflation will rise and the value of money will decrease. If the money supply is too tight, inflation will not be an issue but the economy will falter due to lack of investment, and this will result in an increase in unemployment.