Macroeconomic Impact on Business Operations
The Federal Reserve Board uses tools to control the money supply in the United States, which are open-market operations, the reserve ratio, and the discount rate. These tools influence the money supply and affect macroeconomic factors, which I will discuss in detail. I will also explain how money is created in a macroeconomic system, and recommend monetary policy combinations to best achieve a balance between economic growth, low inflation, and a reasonable rate of unemployment.
Feds Tools of Monetary Control
The Fed has three tools that are used for monetary control in altering the reserves of commercial banks. The money supply is the total amount of currency plus deposits held by the public. These tools can alter economic growth, change the rate of inflation, the level of employment, and adjust the exchange rate, by expansionary or contractionary monetary policy.
The amount of money circulating in the economy can be adjusted through open-market operations, specifically with selling and purchasing of U.S. Treasury and federal agency securities bonds in the bond market. The Federal Open Market Committee (FOMC) will decide on a short-term objective for open market operations. This objective can be a chosen quantity of reserves, or a desired price (federal funds rate). The federal funds rate is the interest rate at which commercial banks lend balances at the Federal Reserve to other depository institutions overnight. ”If the Fed believes that the economy is overheating (if the supply of money is outpacing production of goods), it will raise interest rates and bring money supply down to what it perceives to be the “equilibrium” level. With the same thought, if the Fed believes economic growth is outpacing money supply (causing deflation/less inflation), it will reduce interest rates. When interest rates are lower, it’s cheaper for individuals to take out loans to start new businesses or buy goods and services. This also discourages them from keeping their money in a bank account, because they would make less interest” (NematNejad, 2007). The open-market operation is considered the most common tool used by the Fed, because bonds are bought and sold every week day in New York City.
The Reserve Ratio
The Fed has control over the reserve ratio, which determines the lending ability of commercial banks. The reserve ratio stipulates how much a bank is required to keep in reserves relative to what is in deposits. If a bank has a reserve ratio of 15%, the required reserve on $10 million in deposits is $1.5 million. The required reserve ratio is dictated to be certain banks do run out of cash on hand to meet the demand for withdrawals. The money not required in be on hand is then loaned out to customers, which in turn, increases the money supply.
The Discount Rate
The Federal Reserve Bank is a lender of money to commercial banks. When commercial banks borrow from the district central bank with a promissory note, the interest charged is referred to as the discount rate. The borrowed money will then increase the commercial bank’s reserve, which increases their lending ability. The discount rate is determined by the Fed, and this will be the cost of attaining the reserves. If the Fed were to lower the discount rate, more commercial banks would be inclined to borrow to obtain additional reserves, which would lead to more money in the economy. The same works in reverse for decreasing the money supply.
Creation of Money
Using the tools previously identified, the Fed can increase the supply of money, in other words, create money. During a period of expansionary monetary policy, decreasing the reserve ratio will result in more money commercial banks are able to lend to customers. By lowering the discount rate, the Federal Reserve Bank will lend more money to commercial banks. With commercial banks increasing reserves, the amount available for lending increases, which results in increases in the money supply. The open-market operation of buying and selling of government bonds is the most commonly used tool the Federal Reserve Bank uses to create money. If the economy is showing signs of recession and unemployment, the Fed will buy securities to increase commercial bank reserves. By increasing the commercial bank reserves, as previously discussed, the lending of the reserves will result in the creation of money.
The goals of reaching low inflation, economic growth and a reasonable rate of inflation may sometimes conflict with one another. “One kind of conflict involves deciding which goal should take precedence at any point in time. For example, suppose there’s a recession and the Fed works to prevent employment losses from being too severe; this short-run success could turn into a long-run problem if monetary policy remains expansionary too long, because that could trigger inflationary pressures. So it’s important for the Fed to find the balance between its short-run goal of stabilization and its longer-run goal of maintaining low inflation” (Federal Reserve Bank of San Francisco, 2004).
Recommended Monetary Policy
Monetary policy has become the policy of choice when determining the levels of the money supply. The advantages over fiscal policy are the speed and flexibility, and the isolation from political pressure (McConnell and Brue, 2004). Using the open-market operation, the Fed can purchase or sell government securities daily to affect the money supply and interest rates without much delay. Working in combination with reserve requirements, and discount rates, the Federal Reserve Bank can manipulate the application of monetary policy to achieve a balance between economic growth, low inflation, and a reasonable rate of inflation. The easy money policy was applied to the recession of 1990. The decision to increase the supply of money increased the aggregate demand which resulted in the use of inactive resources.
The decision to increase the money supply may have an adverse effect on the economy; excessive spending. Overactive spending may lead to an inflationary economy, which is remedied by selling securities, increasing the required reserve ratio, and raising the discount rate offered to commercial banks. The policy incorporating these actions is called a tight money policy. The reason for a tight money policy is to decrease spending and control inflation. To achieve an environment of a stable economy, finding the balance between easy and tight money policies is crucial. A quote from Milton Friedman (1968) states “The first and most important lesson that history teaches about what monetary policy can do — and it is a lesson of the most profound importance — is that monetary policy can prevent money itself from being a major source of economic disturbance.”
Managerial Decision Making
In the University of Phoenix simulation (2008), scenarios are presented to students regarding monetary policy. The student is allowed to make decisions which affect the Real Gross Domestic Product (GDP), inflation, and unemployment levels. In the first scenario, global developments have caused the economy to sag, and industrial production to slow. Although inflation looks to be under control, the Real GDP is falling, and unemployment is on the rise. The solution to this scenario can be a combination of increasing the Discount Rate (DR) – Federal Funds Rate (FFR) percentage spread, raising the reserve ratio slightly, and selling approximately $750 million in government securities. The results of my choices were almost a 1% increase in the Real GDP, a tenth of a percent rise in inflation, and a 0.8% drop in unemployment. By selling securities, the supply of money goes up, along with inflation. The unemployment rate does the opposite of Real GDP. If investment and spending rises, demand rises, therefore, increasing the opportunities in the workforce. Unemployment will decrease with the rise of the Real GDP. Ideas from the simulation on how to use monetary policy tools of discount rate, reserve ratio, and open-market operations helps me understand how the supply of money is controlled.
The three tools of monetary policy include the open-market operations, the required reserve ratio, and the discount rate. Together, these tools will be applied to either expansionary or contractionary policy during times of recession or growth. The policies will influence those who can create money. As the Fed lowers the required reserve ratio, banks have more flexibility when lending money. Lowering the discount rate allows commercial banks to borrow more from the Federal Reserve Bank, which also increases the availability of money for lending. But the most commonly used tool is the open-market operation, where the government sells and buys securities to increase commercial bank reserves. The tool is used every day of the week. Monetary policy is the policy of choice, with its speed and flexibility, and separation from political pressure. The Fed can act quickly to respond to inflation, unemployment, and economic growth.
Brue, S.L., McConnell, C.R. (2004). Economics: Principles, Problems and Policies, 16e. The McGraw-Hill Companies
Federal Reserve Bank of San Francisco. (2004). About the fed. Retrieved February 1, 2008, from http://www.frbsf.org/publications/federalreserve/monetary/goals.html
Friedman, Milton, “The Role of Monetary Policy”, American Economic Review, 1968: p.12.
NematNejad, A. (2007). Best way to invest. Monetary policy. Retrieved February 2, 2008, from http://www.bestwaytoinvest.com/monetary-policy.
University of Phoenix, (2008). Economics for managerial decision making [Computer Software]. Retrieved February 2, 2008, from University of Phoenix, rEsource, Simulation, MBA501-Forces Influencing Business in the 21st Century Web site.