Monetary+Policy


 * Fundamental Questions **

> The Federal Reserve is the central bank of the United States. As such, the Fed provides currency, 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. > The **Federal Open Market Committee (FOMC)** is the policy-making body of the Federal Reserve. It consists of the seven-member Federal Reserve Board and five of the twelve Federal Reserve Bank presidents, who serve on a rotating basis. The FOMC issues directives to the Federal Reserve Bank of New York, which implements its directives. > 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. > 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 higher the reserve requirement, the smaller the amount of deposits banks can create and the smaller the money supply. The discount rate is the rate of interest that the Fed charges banks. If the Fed wants to increase the money supply, it lowers the discount rate. Open market operations are the buying and selling of bonds to change the money supply. The Fed buys bonds if it wants to increase the money supply and sells bonds to decrease the money supply. Open market operations are the Fed's most important tool. > Central banks may intervene in the foreign exchange market to stabilize or change exchange rates. For example, the Fed might buy euros to bolster the price of the euro if U.S. goods and services become too expensive for the Europeans. > 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. The demand for money is negatively related to the interest rate. > 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. So increases in the money supply are expansionary, whereas decreases in the money supply are contractionary. > The ECB is the central bank of the 12 nations adopting the euro as their national currency. As such, it conducts monetary policy for the euro region.
 * 1) **What does the Federal Reserve do?**
 * 1) **How is monetary policy set?**
 * 1) **What are the tools of monetary policy?**
 * 1) **What role do central banks play in the foreign exchange market?**
 * 1) **What are the determinants of the demand for money?**
 * 1) **How does monetary policy affect the equilibrium level of real GDP?**
 * 1) **What does the ECB do?**