The Supply of Money

The Federal Reserve controls the U.S. money supply by affecting member bank reserves with open-market operations and adjustments in discount rates and by adjusting reserve requirements for deposits. Open market operations are the major instrument of monetary control.

Open-market operations affect member bank reserves dollar for dollar and have a multiplier effect on the equilibrium money supply. Because member banks are required to hold only a fraction of their deposits as reserves, each dollar of reserves supports several dollars of deposits.

The multiple expansion of deposits comes about as commercial banks lend out excess reserves or place them in securities and create demand deposits in the process. Multiple contraction of deposits, forced when monetary authorities induce shortages of reserves, comes about as the banking system sells off loans and securities to the nonbank public and reduces the demand deposits of the purchasers as payment.