Macroeconomic Impact on Business Operations
A. What are the tools used by the Federal Reserve to control the money supply?
There are 3 main tools used by the Fed to control money supply, namely, Required Reserve Ratio, Discount Rate and Open Market operations.
Required Reserve Ratio is the percentage of bank’s total deposits that a bank must keep as reserves at the Fed. This ratio is fixed or controlled by the Fed, incase this ratio is increased, it decreases the ability of a bank to loan out money, this discourages banks to loan out money and hence money supply reduces and vice versa.
Discount Rate is the rate of interest banks pay to the Fed. An increase in the discount rate by the Fed would have similar impacts to the money supply as the Required Reserve Ratio. It would discourage banks from lending money to people, decreasing the money supply and vice versa.
Open market operations includes issuance of bonds and T-bills in the market. Incase the Fed wants to reduce Money supply it simply issues bonds and T-bills to people, hence people exchange their money for a piece of paper and hence money circulating in the economy is reduced. Banks may do the opposite later, i.e. buy back these bonds when it wants to increase the money supply.
B. How do these tools influence the money supply and in turn affect macroeconomic factors?
Incase of an increase in the Money supply, which may be caused by using any of the three tools available to the Fed, following will be the implications:
Interest rates (r) will fall
Investments by firms (I) will increase
With increase in I, which is a component of the GDP, the GDP will rise
Increase in GDP will in-turn increase the money demand, in the long-run due to the decrease in Unemployment and increase in Inflation
C. How is money created?
In order to understand the concept of money creation it is important to understand the concept of M1 and M2 monies. Economists have defined numerous measures of the money supply to pin-point the impact of money supply changes on our economy’s health. M1 is the basic measure of our money supply. M1 includes coins and currency in people’s hands plus the funds available in checking accounts. M1 functions as the primary medium of exchange in our economy. M2 is a broader definition of the money supply and includes M1 plus savings accounts, certificates of deposit, and money market funds (Case and Fair, 2004).
Money is created in the economy by banks. It is the banks who loan out money to the people and this is what results in the creation of money. Banks are financial institutions which earn money on the spread, i.e. the difference between the discount rate, which is the interest rate applied by the Fed on the banks and the interest rate it charges to its consumers when issuing loans. In order to better understand the concept of money creation it is important to understand the concept of ‘Reserves’ of a bank. Reserves are the deposits a bank has at the Federal Reserve Bank plus its cash on hand. Therefore,
Excess Reserves = Actual Reserves – Required Reserves
Banks may lend an amount equal to their remaining reserves or excess reserves. Banks earn revenue and profits through lending and charging interest on loans. They also increase or decrease the checking deposit component of the money supply through lending.
Now, let us assume a ‘Single Bank Economy’ and a bank receives $100 in deposits, then its reserves will also initially equal its reserves, i.e. $100 (as depicted in Panel 2 in the figure below). The bank knows that it’ll never be called on to any of its $100 in reserves. It can expand its loans up to the point where its total deposits are $500 (assuming a required reserve ratio of 20% OR money multiplier of 5). Now if the Bank places all its money to the Fed in the required reserves, it’ll be able to give out Loans of $400. This increases the money supply by $400, and hence money is created in the economy. This can be depicted in the following figure:
Panel 1 Panel 2 Panel 3
D. Which combinations of monetary policy help you to best achieve a balance between economic growth, low inflation, and a reasonable rate of unemployment?
The Fed uses its powers to influence events in the goods market as well as in the money market, and this is the center of the Govt.’s monetary policy. Two of the Fed’s main goals are higher levels of output and employment and low rate of inflation. From the Fed’s point of view, the best situation is a fully-employed economy with a low inflation rate.
If the economy is in a low output/ low inflation situation, it will be producing on a relatively flat portion of the aggregate supply (AS) curve. In this case the Fed can increase out by using an expansionary monetary policy with little effect on the price level. The increase in the Money supply will shift the aggregate demand (AD) curve to the right, leading to an increase in output and employment with little change in the price level.
(McConnell and Brue, 2005)
The opposite is true in times of high output and high inflation. In this case the economy is producing on a relatively steep portion of the AS curve, and the Fed can decrease the Money supply (tight or contractionary monetary policy) with little effect on output and employment. The decrease in money supply will shift the AD curve to the left, which will lead to a fall in the price level and little effect on output.
(McConnell and Brue, 2005)
E. To illustrate policy, talk about monetary and fiscal policy in the context of a macroeconomic problem.What recommendation would you have to address your problem? Here, find an article by someone who discusses the problem you’ve defined.
AN EXAMPLE OF MACRO-ECONOMIC PROBLEM
Higher Interest rates reduce investment: Housing and mortgages in 2000 (Problem Definition)
Between October 1998 and May 2000, the interest rates on 30 year fixed rate mortgages jumped from 6.71% to 8.52%, largely as a result of an expanding economy (which was shifting the money demand curve to the right) and an increasingly resistance Fed holding the line on money supply growth.
Consider the effect of such an increase in rates on the real monthly cost of buying a home. A potential buyer considering purchase of a $100,000 home with 20% down faced $517 monthly payment in 1998 and a $616 monthly payment in 2000. The effects of raising interest rates are discussed in a Wall Street Journal Article by Nicholas Kulish.
According to him, the housing sector as a result showed signs of cooling even more with the passage of time. A 5.4% drop in work on single-family homes in fueled the decline.
“If you’re a home builder you are not very happy about it, but if you’re the Fed you probably are”, said Jim Glassman, senior US economist for Chase securities (Kulish, 2000). This slowed the growth of the US economy leading to increase rates of unemployment, with decrease in investments by the firms, which would cause a multiplier effect on the GDP, this may even in the long-run lead to a decrease in the GDP if certain counter measures aren’t taken.
What has happened in this case may have been primarily caused by a Expansionary Fiscal policy, with the Govt. increasing its expenditure or decreasing the taxes, leading towards a growing economy, increasing money demand and inflation in the process. This ultimately would cause the interest rates to rise. What Fed could do in this case would be to increase money supply in order to decrease the interest rates using any of the 3 tools available.
Case, Karl E. & Fair, Ray C. (2004). Principles of Economics (7th edition).
McConnell Campbell R. & Brue Stanley L. (2005). Economics.
Kulish, Nicholas (2000).Housing Sector indicates cooling on rate fears. Wall Street Journal. A, 15.