Macroeconomic Impact on Business Operations

Introduction
One of the methods the United States government uses attempting to control the economy is its monetary policy. The United States Federal Reserve Board is responsible for monitoring the economy, advising the President, and setting monetary policy. This paper analyzes monitory policies available to the United States Federal Reserve Board and discusses how these policies affect macroeconomic indicators and the monetary supply. This paper will identify tools used by the Federal Reserve Board to control the money supply and explain how these tools influence the money supply and in turn affect macroeconomic factors. It will explain how money is created relative to the economy and discuss recommended monetary policy combinations that best achieve a balance between economic growth, low inflation, and a reasonable rate of unemployment.

Tools Used by the Federal Reserve Board
The three main tools used by the Federal Reserve Board to control money supply are open market operations, manipulating the reserve ratio, and manipulating the discount rate. Open market operations are the most common tool used and signify the buying and selling of securities from and to commercial banks or the public. Securities are government bonds that have been purchased by the Federal Reserve Banks. They consist largely of Treasury bills, Treasury notes, and Treasury bonds issued by the United States government to finance past budget deficits. When the Federal Reserve Board wants to expand the economy it will use the buying of securities method. This increases the excess reserves of commercial banks while reducing of commercial bank holdings of securities. This allows them more money to inject into the economy through loans to the public. There is a slight, but important, difference in purchases of securities from the public. When the Federal Reserve Board purchases securites from the public, commercial banks excess reserves increase, but only by the amount of the reserve ratio, which will be explained shortly. This is because the public deposits the payment from the Federal Reserve Board into their bank accounts and only the portion required by the reserve ratio is put in reserve. In contrast, when the Federal Reserve Board wants to contract the economy it will use the selling of securities method. Commercial banks purchase securites by drawing from their reserves. This will decrease the amount of money available for them to loan to the public. Also by selling to the public, commercial bank reserves decrease, but only by the amount of the reserve ratio.

Commercial banks are required to keep a percentage of their checkable-deposits in reserve, to cover withdrawals by their customers. The reserve ratio is the specified percentage of checkable-deposit liabilities that a commercial bank must keep as reserves, it is the ratio of the required reserves the commercial bank must keep to the bank's own outstanding checkable-deposit liabilities. Commercial banks will keep their reserves above the reserve ratio, the amount of reserves above the reserve ratio is considered excess reserves. Excess reserves are what commercial banks use when they loan money to customers. By lowering the reserve ratio the Federal Reserve Board would, in effect, expand the economy because it would increase the reserves held in excess and increase the amount of money available to the commercial banks for lending. When the Federal Reserve Board wants to contract the economy it could raise the reserve ratio, which would decrease the amount of money commercial banks have in excess reserves which would decrease the amount of money available for lending. Currently the Federal Reserve Board sets the reserve ratio based on net transaction amounts. The reserve ratio for transaction amounts of 0 to 8.5 million dollars is zero percent, for amounts of 8.5 to 45.8 million dollars the ratio is three percent, for amounts more than 45.8 million dollars the ratio is ten percent. These ratios went into affect on December 21, 1996.

One of the functions of a central bank is to be a lender of last resort. When commercial banks loan out more money than they have in excess reserves, they need a place from which to borrow the necessary amount to cover the difference. Commercial banks can borrow from other banks or from the Federal Reserve Bank. The rate of interest the Federal Reserve Bank charges for loans is called the discount rate. This type of transaction increases the amount of excess reserves that the commercial bank has available. These loans are short-term and are usually from the Federal Reserve Bank in the lending commercial bank's district. By lowering the discount rate the Federal Reserve Board will encourage short-term lending by commercial banks which increases its excess reserves and increases the amount of money available for lending. By raising the discount rate the Federal Reserve Board discourages lending from Federal Reserve Banks and commercial banks will turn to each other to borrow the necessary funds needed to cover their reserves. When commercial banks borrow from each other there is no increase in over-all reserves because the excess reserves of one bank becomes the necessary reserves of another.

The Creation of Money
After a commercial bank is formed it expects the public to deposit its money into the bank for safe keeping. As per the previous section, the commercial bank is required to keep a specified percentage of its deposits in reserve with the Federal Reserve Bank in its district. Commercial banks usually expect to grow its holdings of checkable-deposits in the future, so instead of instead of sending just the required minimun to the Federal Reserve Bank for reserves it will send a higher amount. This allows the commercial bank to avoid constant shipment of money to the Federal Reserve Bank, however it also provides a way for the commercial bank to create money. One of the other functions of a commercial bank is to loan money to the public. The transaction of a loan allows the public to swap something that is not accepted as money, an IOU, for something that is, cash. Normally the public will exchange the money for goods, which will put the money back in the banking system. The money will be put back into the banking system as a checkable-deposit and only a portion of it will go back into the reserves. The amount of money that was not put back into the reserve is the amount of newly created money. If there were no controls on these types of transactions the amount of money held in reserve would decrease to zero. The public would soon realize that the commercial banks had no money to cover their checkable-deposits and create a "run" on the banks to try and receive the money it had deposited. This happened quite often in the early history of our banking system, however modern our modern banking system has numerous controls. One such control is that a commercial bank is not allowed to lend money above the amount it holds in excess reserves. Once a commercial bank has loaned an amount equal to its excess reserves it is considered loaned out.

Recommended Monetary Policy Combinations
In order to find recommended monetary policy combinations the current state of the economy must be determined as well as the current economic trends. The goal of the Federal Reserve Board is to achieve and maintain price-level stability, full employment, and economic growth. If the money supply is low and the real GDP is far below the full-employment output, the economy must be experiencing recession and substantial unemployment. In this case the Federal Reserve Board should institute policies that make it easier for the public to obtain money. It should increase the money supply by purchasing securities from commercial banks and the public, lowering the reserve ratio, and lowering the discount rate. This combination of methods is called an easy money policy. The intended outcome will be an increase in excess reserves in the commercial banking system which increases the amount of money available for lending. This increase in money supply will lower the interest rate, increase investment, aggregate demand and equilibrium GDP.

If, on the other hand, the money supply is high, interest rates low, and aggregate demand is high, the economy is experiencing inflation. The methods the Federal Reserve Board will use to curb spending is selling of securities to commercial banks and the public, increase the required reserve ratio, and increase the discount rate. This will reduce the amount of excess reserve holdings of commercial banks, which will decrease the amount of money available for lending. Because money will be hard to get these methods are said to be a tight money policy.

Monetary policy has two main advantages over fiscal policy. One is speed and flexibility and the other is isolation from political pressure. Compared with fiscal policy, monetary policy can be quickly altered. Congressional deliberations may delay the application of fiscal policy for months, however the Federal Reserve Board can buy and sell securities on a day to day basis. The Board of Governors of the Federal Reserve Board are appointed and server 14-year terms, this isolates them from lobbying and allows them to not worry about being re-elected.

Conclusion
This paper identified the most common tool used by the Federal Reserve Board to control the money supply as open market operations, which is the buying and selling of securities from/to commercial banks and the public. The affect of these tools on the money supply and macroeconomic factors is the expansion or contraction of the monetary supply. by explaining how money is created a better understanding is gained on how the Federal Reserve Board is able to control the economy. Recommended monetary policy combinations depend on the current state of the economy and the current economic trends. To achieve a balance between economic growth, low inflation, and a reasonable rate of unemployment, monetary policies are instituted according to the current economic needs of the country.

References
McConnel-Brue (2004) Economics: Money, Banking, and Monetary Policy. New York: The McGraw-Hill Companies.

The Federal Reserve, Reserve Requirements. Retrieved May 8, 2007 from http://www.federalreserve.gov/monetarypolicy/reservereq.htm