1. What does the Federal Reserve do?

The Federal Reserve is the central bank of the United States. As such, the Fed accepts deposits from and makes loans to financial institutions, acts as a banker for the federal government, supervises the banking system, and controls the money supply.

2. How is monetary policy set?

The Fed’s ultimate policy objective is economic growth with stable prices, but it cannot control output or the price level directly. Instead, the Fed uses the money supply as an intermediate target. It controls the money supply, which in turn affects real GDP and the level of prices.

3. What are the tools of monetary policy?

The tools of monetary policy are the reserve requirement, the discount rate, and open market operations. The reserve requirement is the percentage of deposits that financial institutions must keep on hand or at the Fed. The discount rate is the rate of interest the Fed charges banks. Open market operations are the buying and selling of bonds to change the money supply.

4. What role do central banks play in the foreign exchange market?

Central banks may intervene in the foreign exchange market to stabilize or change exchange rates. For example, the Fed might buy francs to bolster the price of the franc if U.S. goods and services became too expensive for the French.

5. What are the determinants of the demand for money?

There are three aspects to the demand for money. Consumers and firms demand money in order to conduct transactions (the transactions demand for money), to take care of emergencies (the precautionary demand for money), and to be able to take advantage of a fall in the price of an asset that they want (the speculative demand for money). The amount of money held depends on the interest rate and nominal income. Increases in nominal income generate a greater volume of transactions, so more money is needed. The demand for money is therefore positively related to nominal income. The interest rate is the opportunity cost of holding money. A higher interest rate means that it costs more to hold money, so less money will be held. A higher interest rate means that it costs more to hold money, so less money will be held. The demand for money is negatively related to the interest rate.

6. How does monetary policy affect the equilibrium level of real GDP?

Monetary policy refers to controlling the money supply. An increase in the money supply decreases interest rates, which increases consumption and investment. The increases in consumption and investment increase aggregate demand, which increases the equilibrium level of real GDP. A decrease in the money supply increases interest rates, which decreases consumption and investment. The decreases in consumption and investment decrease aggregate demand, which decreases the equilibrium level of real GDP.