Quick Answer
The Federal Reserve runs monetary policy through open market operations, reserve requirements, and interest rates; the business cycle moves expansion, peak, contraction, trough; leading, coincident, and lagging indicators mark timing; and exchange rates plus gross domestic product (GDP) versus gross national product (GNP) tie it to the global economy.
The whole unit on one sheet: the Fed's levers, the cycle, the indicators, and how it all connects to markets and the dollar.
The Federal Reserve's Toolkit
- The Fed is the central bank, mandate: maximum employment, stable prices, moderate long-term interest rates.
- Monetary policy = the Fed (interest rates, open market operations, reserve requirements). Fiscal policy = Congress and the President (spending, taxation).
- Open market operations (run by the Federal Open Market Committee, FOMC) are the most-used tool: Fed buys securities = expansionary (easing); Fed sells = contractionary (tightening).
- Reserve requirements: raising = contractionary; lowering = expansionary.
- Rate staircase (lowest to highest): federal funds rate, then discount rate, then prime rate (about fed funds + 3%).
The One-Liners That Win Points
- Fed buys bonds → rates down, bond prices up, stocks up, dollar down. Fed sells → the reverse.
- A tightening Fed strengthens the dollar (higher rates attract foreign capital).
- The stock market is a LEADING indicator; the unemployment rate is LAGGING.
- Producer Price Index (PPI) is a leading indicator of the Consumer Price Index (CPI). Wholesale prices rise before consumer prices.
- Recession = two consecutive quarters of declining real GDP.
- GDP = within borders (domestic). GNP = by citizens (national).
- Strong dollar hurts U.S. exporters, helps U.S. consumers buying foreign goods; weak dollar does the opposite.
- Keynesian = fiscal policy (government spending). Monetarist = monetary policy (money supply).
The Business Cycle
- Expansion → Peak → Contraction → Trough, then repeats.
- Cyclical stocks move with the cycle (autos, housing, luxury, travel). Defensive (counter-cyclical) stay stable in downturns (utilities, healthcare, consumer staples, food). Growth stocks reinvest earnings (technology, biotech).
Indicators by Timing
| Type | Timing | Examples |
|---|---|---|
| Leading | Change before the economy | Building permits, stock prices, durable-goods orders, money supply (M2), initial unemployment claims, PPI |
| Coincident | Change with the economy | GDP, personal income, industrial production, retail sales, non-farm payrolls |
| Lagging | Change after the economy | Unemployment rate, corporate profits, average prime rate, CPI for services |
Memory Aid:
- Leading = where we're going (predict)
- Coincident = where we are (describe)
- Lagging = where we've been (confirm)
Top Gotchas
- The Fed does NOT directly set the federal funds rate; it sets a target range. It does directly set the discount rate.
- Bond prices and interest rates are INVERSELY related. They never move the same direction.
- "Defensive" stocks are NOT defense/military stocks; they sell essentials (utilities, food, healthcare).
- Balance sheet = a snapshot (point in time); income statement = a period of time. "Financial position on December 31" means the balance sheet.
- A trade deficit means imports exceed exports (the U.S. buys more than it sells). A current account deficit is offset by a capital account surplus.
- Unemployment cluster: initial claims = leading, non-farm payrolls = coincident, unemployment rate = lagging.
One-Breath Recap
The Fed pulls three levers to steer money and rates, the economy cycles through four phases, and indicators tell you whether you're predicting, describing, or confirming. Nail the Fed-to-dollar chain and the GDP-versus-GNP split, and the international questions answer themselves.
Need more than the recap? This is a condensed summary. If it is not enough, read the full Economic Factors unit for the complete lesson.