The Federal Reserve System

The Fed's main tool for controlling the money supply and influencing interest rates is called open market operations: the sale and purchase of U.S. government bonds by the Fed in the open market. To understand how this process works, we first need to know a few facts:

• The Fed's assets include a substantial dollar amount of government bonds.
• The Fed can buy or sell these bonds on the open market (consisting primarily of commercial banks).
• Because member banks use cash to buy these bonds, they decrease their reserve balances when they buy them.
• Because member banks receive cash from the sale of the bonds, they increase their reserve balances when they sell them.
• Banks must maintain a specified balance in reserves; if they dip below this balance, they have to make up the difference by borrowing money.
  

If the Fed wants to decrease the money supply, it can sell bonds, thereby reducing the reserves of the member banks that buy them. Because these banks would then have less money to lend, the money supply would decrease. If the Fed wants to increase the money supply, it will buy bonds, increasing the reserves of the banks that sell them. The money supply would increase because these banks would then have more money to lend.