Macroeconomic Impact on Business Operations
Macroeconomic Impact on Business Operations
Introduction
Macroeconomics is the study of the economy as a whole. A thriving economy will create money and produce goods and services for consumption. Economic systems are influenced by macroeconomic factors. A country will strive for sustainable economic growth to improve the standard of living for its citizens. Fiscal and monetary policy is used to influence the economy. A well-defined monetary policy has the ability to control an economy and produce sustainable growth.
Money Creation
Money can be created by a government printing more money or through the banking system. When a government prints more money and spends this in the economy, the actual value of each unit of money already in the economy falls. This reduction of value for each unit of money is known as inflation. When a government prints money to finance a war or other purpose, hyper-inflation usually occurs. One unit of money in the current period is worth substantially less in a near future period. Creating money in this manner is not good for an economy.
A better way to create money is to use the banking system. In the United States, the banking system must keep reserves (amounts of money based on deposit levels at the Federal Reserve Bank in non-interest bearing accounts that can not be used for any other purpose) When a bank makes a loan to an individual or business, money is created. The money is created because the bank puts the proceeds of the loan into a checkable account for the borrower. This increases both sides of a banks balance sheet and "increases" the money supply. Since the lending bank must keep a required reserve, the full amount of the loan does not enter the money supply. The increase in the money supply is not limited to the lending bank. The reserve amount stays out. This ratio is controlled by the Federal Reserve System. The money that the borrower spends increases the checkable accounts of the sellers of goods that the borrower purchased with the loan proceeds. This process compounds the effect of the original banks loan. The actual amount of created money is reciprocal to the required reserve rate (M=1/r, where r = the reserve rate). Banks are able to continue to create money as long as they meet their reserve requirements.
Banks can create money by purchasing bonds from the public or government. Purchasing bonds adds checkable deposits to the sellers that can be used to purchase goods and/or services. The total effect on the money supply is comparable to the loan example above.
Monetary Policy
An economy can be affected by fiscal or monetary policy. Fiscal policy is enacted by the government through legislation and monetary policy is determined by economic policies enacted by the Federal Reserve System. Direct legislation by the government can be affected by political agendas and may not be implemented in an unbiased way that best benefits an economy. "Because monetary policy works more subtly, it is more politically palatable (McConnell, 2005, pg 305).
Monetary policy has two advantages over fiscal policy: 1) speed and flexibility and 2) isolation from political pressure. Monetary policy ...
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Monetary Policy
An economy can be affected by fiscal or monetary policy. Fiscal policy is enacted by the government through legislation and monetary policy is determined by economic policies enacted by the Federal Reserve System. Direct legislation by the government can be affected by political agendas and may not be implemented in an unbiased way that best benefits an economy. "Because monetary policy works more subtly, it is more politically palatable (McConnell, 2005, pg 305).
Monetary policy has two advantages over fiscal policy: 1) speed and flexibility and 2) isolation from political pressure. Monetary policy changes can be quickly enacted by the Federal Reserve System on a daily basis and there are many different methods available to accomplish the same goal. The governors of the Federal Reserve System are appointed for 12 year terms and are insulated from the normal political pressures (McConnell, 2005, pg 304).
Monetary policy does have limits and possible problems. There is difficulty in recognizing what is happening in the economy and this leads to timing issues in getting the actual policy changes made. Changes in the velocity of money (how many times in a certain period that the same money is used - a large turnover or a small turnover) can reduce the effectiveness of policy changes. Even though the policies are in effect to increase borrowing and spending during a recession, there is normally a reluctance of businesses and consumers to borrow and spend in this type of economic period.
Monetary policy is a process that is used to control the money supply of an economy. The "object of monetary policy is to influence the performance of the economy as reflected in such factors as inflation, economic output, and employment. It works by affecting demand across the economy-that is, people's and firm's willingness to spend on goods and services" (Federal Reserve Bank of San Francisco, 2004). Monetary policy is accomplished by maintaining, increasing or decreasing the money supply. The level of the money supply and the ease or difficulty of obtaining money directly affects the strength of an economy. Monetary policy works because the United States banking system is a fractional reserve system. A fractional reserve system requires banks to keep part (a percentage or fraction) of their money in the Federal Reserve Bank. This percentage of money can not be used for productive purposes.
The Federal Reserve affects the money supply by using three tools: 1- Open-market operations (the buying or selling securities - this will change checkable deposits by adding or removing money from the buyer/seller), 2- Reserve Ratio (lowering or raising banking reserve requirements - changes the amount of money available for making loans or purchasing securities by changing the amount of money a bank must "leave" at the Federal Reserve Bank) and 3- Discount Rate (the lowering or raising of the discount rate at the Fed Window - makes borrowing from the Federal Reserve more advantageous or less advantageous for a bank). The first option in each of the above parameters will increase the money supply and the latter will decrease the money supply.
Effect of Monetary Policy on Macroeconomic Factors
The macroeconomic factors are: gross domestic product, unemployment, inflation and interest rates. Monetary policy affects each of these factors in unique ways. Identifying the factor that one must change and properly adjusting monetary policy to affect the desired change is the challenge for monetary policy.
Gross domestic product (GDP) is a combination of personal consumption, investment, government purchases and net exports. GDP is affected when any of the factors are changed or influenced. Monetary policy affects GDP by changing one of the underlying factors. GDP is "the total market value of all final goods and services produced in a country in a given year, equal to total consumer, investment and government spending, plus the value of exports, minus the value of imports" (Webfinance, 2005). Increasing the money supply will increase GDP. Decreasing the money supply will decrease GDP. A positive growth in GDP is a major goal of economies. A higher GDP increases the current and future standard of living.
Unemployment is defined as the number of persons who do not have a job and are seeking a job. When workers are unemployed, the country as a whole loses. The worker loses wages that could be used for consumption and the country loses the goods or services which could have been produced (U. S. Department of Labor, 2001). If the money supply increases, unemployment reduces. As money becomes available in an economy, more products and services are demanded and the demand for workers increases. There is a time lag but the demand does occur. A change in monetary policy does not change frictional or structural unemployment that are natural results of the business cycle.
Inflation is defined as "a persistent increase in the level of consumer prices or a persistent decline in the purchasing power of money, caused by an increase in available currency and credit beyond the proportion of available goods and services" (Answers.com, 2006). Inflation will decrease real GDP over time and negatively affect most monetary factors. Inflation is good for borrows because they will pay back their debt with dollars (or other currency) that are worth less than the ones that were borrowed. This effect also benefits the federal government with the national debt. With an increase in the money supply, inflation will increase. As more dollars chase the same number of goods, the price of the goods will increase. This is called demand pull inflation. A decrease in the money supply will not necessarily reduce inflation.
Interest rates are the percent of an amount a lender demands for the use of a certain amount of money (McConnell, 2005, pg 804). As demand for money increases, the interest rate necessary to obtain the money rises. Therefore, an increase in the money supply will lower interest rates in the economy. The demand for money is also affected by consumer beliefs, the business cycle and business perceptions. Any rise in these factors could counteract the affect that monetary policy has on the interest rate.
Recommended Monetary Policy
Monetary policy has two basic goals: "to promote maximum sustainable output and employment and to promote stable prices" (Federal Reserve Bank of San Francisco, 2004). To obtain these goals, all three monetary tools can be used. The Federal Reserve System uses the Fed Funds rate as an indicator of policy direction. They complete the actual rate changes with demand modifications using open market operations. Rarely is reserve requirement changes used as they affect profitability access of banks. The discount window rate is the second most used tool but it has limitations due to competition from the Fed Funds and bank reluctance. Open market operations are the tool that is used to affect monetary policy by the Federal Reserve System.
When the economy is growing there is a tendency for inflation to increase. Current economic outlook by the Federal Reserve System considers inflation a major concern "the FOMC decided to extend the firming of policy that it had implemented over the previous eighteen months by tightening the policy rate 25 basis points, to 4-1/2 percent" (Federal Reserve, 2006). Therefore, open market operations were performed that would lower interest rates by 1/4 %. This increased the money supply to help increase GDP and lower unemployment and is believed to be a small enough increase to keep inflation from rising. This is the Federal Reserve System's recommended monetary policy and the policy that the author recommends.
Conclusion
Money creation and control is determined by fiscal and monetary policy. A sustained economic growth indicated by an increase in gross domestic product is desired by economic systems. Monetary policy is the most effective way that governments have in influencing economic conditions. Monetary policy will affect gross domestic product, inflation, unemployment and interest rates in an economy. The proper use of monetary policy by governmental entities will enable an economy to attain sustainable growth and reduce the effects of inflation. Gross domestic product growth will also reduce unemployment in an economy.
The current United States Federal Reserve monetary policy of increasing the money supply is perceived as a means to slowly increase GDP, reduce unemployment and keep inflation stable. This policy is the current recommended policy by the author as the best to produce sustainable economic growth and keep inflation stable.
References
Answers.com (2006). Inflation, Retrieved October 23, 2006 from http://www.answers.com/topic/inflation
Federal Reserve (2006). Monetary policy report to congress, July 19, 2006. Retrieved October 23, 2006 from http://www.federalreserve.gov/boarddocs/hh/2006/july/ReportSection1.htm
Federal Reserve Bank of San Francisco (2004). U.S Monetary Policy: An Introduction. Retrieved October 23, 2006 from http://www.frbsf.org/publications/federalreserve/monetary/MonetaryPolicy.pdf
McConnell, Campbell R. and Brue, Stanley L. (2005). Economics: Principles, problems, and policies (16th ed.). New York: McGraw-Hill Companies.
U. S. Department of Labor (2001). How the government measures unemployment, Retrieved October 23, 2006 from http://www.bls.gov/cps/cps_htgm.htm
Webfinance (2005), Investorwords.com: GDP, Retrieved October 23, 2006 from http://www.investorwords.com/2153/GDP.html