How does the Fed Control Money Supply?
As we discussed earlier, the money supply is an important piece of the puzzle to maintain economic balance and if this does not happen, a recession can take hold. When there is a heavy injection of money supply into our monetary system, known as “loosening”, inflation will be the result. Remember the supply/demand construct; when people have more money to spend, higher prices for the consumer will result. Reducing the money supply by increasing the “reserve requirement”, referred to as “tightening”, requires the banks to hold more in federal funds which reduces their leverage ratio. The leverage ratio measures the banks ability to leverage their demand deposits as loans. The Fed can also use the treasury auctions to expand and contract the money supply. When the Fed sells treasury bills, notes, and bonds, they are essentially pulling money out of the system and issuing a security in its place. This security does not count as part of the money supply equation. Conversely, when the Fed c
