Macroeconomic Impact

Macroeconomic Impact

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Macroeconomic Impact on Business Operations

Many have heard the phrase "Money makes the world go round", but where does money come from? The United States, like most other countries today, has a fractional reserve banking system in which only a fraction of the total money supply is held in reserve as currency. Early traders began to use gold in making transactions; they soon realized that it was both unsafe and inconvenient to carry gold and to have it weighed every time they negotiated a transaction. By the late sixteenth century, they had begun to deposit their gold with goldsmiths, who would store it in vaults for a fee. On receiving a gold deposit, the goldsmith would issue a receipt to the depositor. Soon people were paying for goods with goldsmiths' receipts, which served as the first kind of paper money. On receiving a gold deposit, the goldsmith would issue a receipt to the depositor. Soon people were paying for goods with goldsmiths' receipts, which served as the first kind of paper money. The goldsmiths observed that the amount of gold being deposited with them in any week or month was likely to exceed the amount that was being withdrawn. Someone came up with the idea that paper receipts could be issued in excess of the amount of gold held. Goldsmiths would put these receipts, which were redeemable in gold, into circulation by making interest-earning loans to merchants, producers, and consumers. Borrowers were willing to accept loans in the form of gold receipts because the receipts were accepted as a medium of exchange in the marketplace. This was the beginning of the fractional reserve system of banking, in which reserves in bank vaults are a fraction of the total money supply. The fractional reserve has two significant characteristics: money creation and reserve which is defined as Banks can create money through lending, and bank panics and regulation: Banks that operate on the basis of fractional reserves are vulnerable to "panics" or "runs" (McConnell & Brue 2005).
Money creation is the process by which the money supply of a country is increased. There are several ways that a government, in coordination with the country's commercial banks, can increase or decrease the money supply of a country. If a country follows a fractional-reserve banking regime, as virtually all countries do, not all of the money in circulation needs to be backed by other currencies, physical assets such as gold, or government assets.

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Instead, the country's currency is backed by the economic potential of the country and is based on decree. The most common mechanism used to generate money is typically called the money multiplier. It measures the amount by which the commercial banking system increases the money supply. To control the amount of money created by the system, central banks place reserve ratios on the commercial banks which set the proportion of primary deposits the banks may not lend out. In the USA this ratio is 10%, in other countries there is no reserve ratio. The reserve ratio is to prevent banks from 1) having a shortage in money when a large demand of deposits is withdrawn 2) limited the amount of money that will be generated. The reserve ratio in US is determined by the Fed and can be altered. There are several steps that the government takes to create new money. The first step happens when the government issues a Treasury security. This is simply an IOU, a promise to pay the holder a specified sum of money on a particular date. The Federal Reserve then prints a check in that amount and makes it payable to the government. This check is the proceeds from the sale of the bonds. The amount of the bonds is recorded as an asset by the Fed. It is assumed the government, with its power to tax, will make good on its debt. The Fed can sell these bonds which are a liability of the government. Individual investors, pension funds, mutual funds, insurance agencies, banks, foreign government central banks, can all buy the bonds, effectively loaning money to the treasury. They do this to invest their money and receive interest in return. The government deposits the check in its own account. The government hires employees and buys things with the amount, and it does so by writing government checks. These government checks are then deposited in commercial banks. The commercial bank now claims 90% in new liabilities. This money is put into reserves, and a portion of that is lent out. As soon as the money is deposited back into the bank, the cycle repeats and repeats until there are no more borrowers. Commercial banks make profit by charging fees for transactions, and by charging a higher interest rate to those they lend to, than what they pay for the funds. If the commercial bank charges 6% interest on, for example, $900,000 it will earn $54,000 per year. If the bank making the loan pays 1% interest to the person who put the money on deposit in the first place it will cost them $10,000 per year. With 90% of that money lent out, if the original depositor wants their money back, the bank has to borrow that money from another bank, at rate of interest set by the government. This is called "asset-liability bouncing", and is a delicate balancing act all banks must work on every day. the money creation multiplier is more complex than the description given above. One must add to the equation the currency drain ratio, the clearing house drain, and the safety reserve ratio, excess reserves beyond the legal requirement that commercial banks voluntarily hold—usually a very small amount. Also, most jurisdictions require different levels of reserves for different types of deposits. Foreign currency deposits, domestic time deposits, and government deposits often have different cash reserve ratios. Whatever the reserve ratio ends up being, after all things considered, the bottom line is that the banking system lends out far more than the amount of money that it takes in, and collects interest on those loans from the public (Wikipedia).
The Federal Resrve uses three specific tools to control the money supply in the United States: Spread between the discount rate (DR) and federal fund rate (FFR), required reserve ratio (RRR), and open market operations (OMO). The spread between the DR and the FFR indicates how banks will react to the market. Banks are inclined to borrow from the Fedreal Reserve if the DR charged by the Fed is lower than the FFR charged by other banks. As the DR is decreased, banks shift their source of borrowing from other banks to the Fed. As they do so, the total amount of money in the system is increased. Also remembered that if the spread is positive ( the DR is above the FFR), the banks will always borrow from the other banks, and will have no effect on the money supply. Required Reserve Ratio is the percentage of the deposits that any bank holds as reserves. The Fed mandates this ratio. If this ratio is decreased, banks are required to hold lesser amounts as reserves can lend that much more to their customers, thus increasing the money supply in the system, since, in trying to meet the requirements, banks end up draining the system. The Open Market Operations is comprised of T-bills, bonds, and other Federal instruments that are sold to the investors. The are typically bought and sold by investors through auctions. Sale of thses intruments typically drain money out the system. Buying these items usually releases money into the system.
The money supply affects the macroeconomic idicators in three ways: Real Gross Domestic Product (Real GDP), the inflation rate, and the unemployment rate. The Real GDP increases with increasing money supply. High levels of money in the system act as a spur for both investment and industrial/consumer demand. This in turn increases the nation's Real GDP. Similarly, any measure that drains money out of the system acts as a disincentive to lower spending and investment and tends to lower Real GDP. The Inflation Rate is increased when the money supply is increased. When the amount of money in the system is increased, the norminal value of money remain the same, but, as more money chases the same quantity of goods and services, the real value of money is decreased. As a result, prices go up there by signaling greater inflation rates. The unemployment rate is invesrely related to the Real GDP. Due to the increased investment and spending, the demand and employment and opportunties for the work force tends to go up since labor is required for production of goods anad services. As they go up, unemployment tends to go down. As money is drained out of the system and Real GDP tends to fall, unemployment opportunnites and demand for work force to fall, thus putting pressure on unemployment ratio (Monetary Policy Simulation).

References:

McConnell, Campbell R. & Brue, Stanley L. (2005). Economics: Principals, Policies,
and Problems. New York: McGraw-Hill, Chapter 14.

Monetary Policy Simulation, 2006. Retrieved from University of Phoenix Online EResource on 01/22/07.
Wikipedia, the free encyclopedia. Online. www.wikipedia.org/moneycreation.

Retrieved on November 23, 2006.
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