Macroeconomic Impact On Business Operations
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Some say money is the root of all evil. Those who have it do not know what to do with it and those who want it dream of having it. The creation of money has always been somewhat confusing. The Federal Reserve uses various tools to control the money supply. Theses tools influence the money supply and in turn affect macroeconomic factors. To better understand the purpose and structure of the Federal Reserve we writing expectations, all instances first have to understand how money is created and which combinations of monetary policy best achieves a balance between economic growth, low inflation, and a reasonable rate of unemployment.
Prior to the creation of money, society would use the barter system to obtain everyday necessities. A prime example of this would be when a farmer harvested his various produce, collected eggs his chickens laid, raised cows for their milk, and pigs for meat. He would take his inventory to town and obtain the things he needed by exchanging his goods for horses, food, or clothing. As time passed gold was discovered and was considered as a form of money where it could be exchanged for the everyday necessities of life. Each time a purchase was made, the gold had to be weighed and have a value placed on it. This became time consuming so a goldsmith would hold the gold and issue receipts for the gold that could be exchanged for goods and services from the different businesses in town.
When someone borrowed gold from the goldsmith, instead of taking the loan in the form of gold, the person accepted the paper IOUs of the goldsmith. Since people accepted these paper IOUs as money, this transaction increased the amount of money in circulation. When the goldsmiths began to create money, their careers as bankers began. (J. A. Ferris,1969)
Monetary policy is the process by which governments and central banks manipulate the quantity of money in the economy to achieve certain macroeconomic and political objectives. The targets are usually economic growth, changes in the rate of inflation, higher level of employment, and adjustment of the exchange rate. Monetary policy is categorized into two types: contractionary and expansionary. Contractionary (or “tight”) monetary policy aims to reduce the amount of money circulating through the economy. Expansionary (“loose”) policy, on the other hand, aims to increase the money supply.
Some of the Tools of Monetary Policy are interest rates, monetary base, and reserve requirements. The Federal Reserve affects interest rates mainly through its open market operations. The Fed can either buy or sell United States government securities. These bonds, bills and notes are all debt guarantees that pay interest until they are repaid. Thirty-year Treasury bonds are the longest-term debt that the government sells.
The Open Market Committee of the Federal Reserve trades in securities as a way to increase or decrease the money supply. If the Fed wants to make a purchase on the open market, it places an order through its trading offices in New York City. The Fed buys the securities from dealers. It credits the amount of the sale to the dealers banks. These banks then have more money to lend, which increases the money supply. More money in the economy can drive down interest rates. People and businesses borrow more when lending costs are low. If the Fed sells securities, this shrinks the money supply and can drive interest rates up. A smaller money supply can ease inflationary pressure. (Ritter, 2006)
The first policy tool the Federal Reserve uses is the required reserve ratio. If the Federal Reserve increases this ratio, the banking system is forced to destroy money, and if the Federal Reserve decreases this ratio the system is encouraged to create money. The second policy tool is the discount rate. One way a bank can obtain reserves is by borrowing them from the Federal Reserve. When the Federal Reserve charges a high interest rate for these borrowings, banks will not borrow as much reserves as when the Federal Reserve charges a low interest rate. The third and only policy tool of importance is open-market operations. In open-market operations the Federal Reserve buys or sells U.S. government securities, usually T-bills, in the secondary market. When the Federal Reserve buys securities, it creates the funds with which it buys T-bills. It pays with a check drawn on it, and when a commercial bank submits this check for payment, the bank gets reserves that did not previously exist. The process by which the Federal Reserve creates bank reserves parallels the process by which banks create money. A major difference is that the creation of bank reserve is not a by-product of a quest for profit. On the contrary, any profit is a by-product of an attempt to maintain some level of reserves. Indeed, if a modern central bank set out to maximize profit, it is doubtful that the monetary system could long survive. (Schenk, 2005).
The Federal Reserve Bank can also use a discount window. This involves three special interest rates that the Fed really does control. Banks can borrow at these rates for short periods. The program serves large or small banks as well as those with seasonal needs, like agricultural banks. Finally, the central bank can change the amount of money that banks are required to keep with the Federal Reserve itself. Increasing the reserves reduces the money supply, since it leaves banks with less money to lend.
If the Fed believes the supply of money is outpacing production of goods, it will raise the interest rates and bring money supply down to what it perceives to be the “equilibrium” level. On the other hand if the Fed believes economic growth is outpacing money supply (causing deflation/less inflation), it will reduce interest rates. The lower the interest rate the cheaper it is for individuals to take out loans to start new businesses or buy goods or services. It also discourages individuals from keeping their money in a bank account, because they make less interest. Occasionally, a central bank will also reduce interest rates to alleviate the economic impact of a major political event. A checking account is nothing more than money that the bank owes you, and paper money represents something that the Federal Reserve System owes.
Money supply consists of currency (Federal Reserve Notes and coins) and checkable deposits. The U.S. Bureau of Engraving creates the Federal Reserve Notes and the U.S. Mint creates the coins. Banks create money through making loans, and accepting deposits. Many depositors of banks, when they acquire loans, want the convenience and safety of paying their obligations by check. They opt to have their loans credited to their checkable-deposit account. These checkable deposits may be thought of as bank debts that banks promise to pay on