Money enters the economy by a process called money creation. Banks create money making loans. When a bank makes a loan of $1000 and deposits money in the borrowers checking account, it increases the money supply by $1,000. The bank can loan out all but the required reserve ratio (RRR), the ratio of reserves to deposits required of banks by the Fed. If the RRR is 10 percent, the bank may loan out $900 of the original $1,000 deposit. The bank can then lend out 90 percent of that $900, and so on.

     The Fed has three tools for adjusting the amount of money in the economy. The simplest is to change reserve requirements. Reducing the RRR means that banks can lend out more money, increasing the money supply. Increasing RRR has the opposite effect.

     A second tool is to adjust the federal funds rate. Both the discount rate and prime rate are affected by changes in the federal funds rate. When the federal funds rate goes up or down, the other two rates also go up or down. When banks lend money at a lower rate, it tends to increase the overall money supply.

     The Fed’s third and most important monetary policy tool is open market operations, the buying and selling of government securities such as bonds. When the Fed wants to increase the money supply, it purchases government securities. The bond seller deposits money from the sale into the bank, starting the money creation process. To decrease the money supply, the Fed sells government securities. The money paid for the bond is taken out of circulation, and reserves are reduced.