Page 524 - Introduction to Business

498 PART 5 Finance

Can the Fed’s monetary policy actions affect you? Recall the scenario in the
introductory part of the chapter. You work for a small pizza business. Also, you are
considering the purchase of a new home due to the birth of a child. An evening
news report indicates that the Fed increased the money supply and lowered inter-
est rates. These lower interest rates will allow your business to borrow money from
the local bank at a lower cost than before. If the Fed’s actions tend to increase eco-
nomic activity, pizza sales will likely increase in the near future. With higher
income, you could afford to buy the new home. Also, lower interest rates might
allow you to get a larger house than you had previously thought possible due to
lower monthly mortgage payments. If you and others are encouraged to buy homes
by the lower interest rate on borrowed funds, home builders will benefit in terms of
sales and more jobs for employees. Also, many consumer durable products go into
new homes, such as refrigerators, ovens, and furniture. Firms making these prod-
ucts would experience increased sales and jobs also. Workers earning higher
incomes can use their money to buy groceries, which is good for grocery stores and
farmers. Central banks can have a powerful effect on the lives of you and many
other people.

Balancing Monetary and Economic Goals. Throughout the post–World
War II period from 1945 to 1979, central banks generally sought to increase output,
or productivity, as measured by the growth of gross national product. The GNP rep-
resents the total value of goods and services produced by a country in a specific
time period. Also, maximum sustainable employment and wage rates were key
areas of concern. These economic policies mean that keeping interest rates rela-
tively low and stable was the primary concern of central banks. Given the terrible
economic conditions during the Great Depression, this emphasis on a healthy busi-
ness sector was certainly reasonable.
The top portion of Exhibit 14.6a shows how central banks maintained low and
stable interest rates using monetary policy. If the demand for money increased,
causing a rightward shift in the demand curve D, higher interest rates would be
prevented by central bank actions to increase the money supply and bring federal
funds rates back into the target interest rate range i*. This policy was successful for
many years, until repeated increases in the money supply periodically caused infla-
tion to increase. Recall that p m – q from the equation of exchange, so increases
in the growth rate of money greater than increases in the growth rate of productiv-
ity (or real economic output) result in higher inflation rates. Higher levels of infla-
tion are difficult for most business firms to manage. Prices or costs of labor and
materials increase more rapidly than normal at such times. A major problem is that
business firms must increase the sales prices of their goods and services to keep up
with the rising costs and maintain their profit margins between costs and revenues.
But raising the prices of goods and services can cause a firm’s sales to slow down, as
some customers choose not to make purchases at higher prices. In this inflationary
business environment, it is difficult for managers to make plans for sales and pro-
duction. In sum, business conditions become very uncertain and unpredictable.
A second problem associated with inflation is that interest rates increase as
inflation rates increase. In fact, the nominal interest rate stated in financial news is
composed of the real rate of interest plus the inflation rate. This simple relationship
is known as the Fisher effect. The real rate of interest is determined by people’s time
preferences for consumption. In other words, people with money have a choice of
either spending (consuming) their money or lending their money to others. Bor-
rowers must pay lenders a rate of interest in order to entice or encourage them to
lend money. This is the real rate of interest. The Fisher effect says that, as inflation
rates increase, lenders want higher interest rates to enable them to earn enough
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