What does the Federal Reserve do? And why are its actions so important?

Road Map The FOMC statement reveals that, to understand the Fed, we need to know both the goals and the tools of the Fed. From the statement, we learn that the goals of the Fed are sustainable growth and stable prices. The Fed cannot do much to affect the long-run growth rate of the economy, but it can and does try to keep the economy close to potential output. At the same time, it tries to ensure that the overall price level does not change very much—in other words, it tries to keep inflation low. The Fed pursues these goals by means of several tools that it has at its disposal. The FOMC statement informs us that these tools include two different interest rates. We begin with a little bit of background information. We briefly explain what the Federal Reserve does, and we note that other monetary authorities are similar, although not identical, in terms of goals and behavior. Because we have seen that the Fed’s actions frequently revolve around interest rates, we make sure that we know exactly what an interest rate is. We then get to the meat of the chapter, which discusses the workings of monetary policy. We explain how the Fed uses its tools to affect the things it ultimately cares about. Broadly speaking, we can summarize the cyclic behavior of the Fed as follows:

 The Fed observes current economic conditions.  The Fed decides on policy actions.  These policy actions affect real GDP (gross domestic product) and inflation.  The Fed observes the new economic conditions.

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There is a long chain of connections between the Fed’s tools and the ultimate state of the economy. To make sense of what the Fed does, we follow these connections, step by step. As we do so, we create a framework for understanding the effects of monetary policy, called the monetary transmission mechanism. We must also look at the connection in the other direction: how does the state of the economy influence the Fed’s decisions?