The money supply represents the whole of deposits in financial institutions, or the money outstanding and not accounted for by any other measure. This money is often very fluid, flowing in and out of the system, and is a key measure of economic health. If the money supply is too much, inflation could result. If it is too little, economic growth may not occur.
Given the dangers of inflation or no growth, the U.S. Federal Reserve, and the central bank of any other country under a monetary policy, will try to control the money supply by a number of different methods. In the end, the overall goal is to provide a balance that will generate sustained growth, but not so much growth as to cause inflation. Both extremes must be guarded against, and economies can change very drastically, making this a very difficult balance to accomplish.
Interest rates are one way of controlling the money supply. The Federal Reserve, or national bank, can arbitrarily change the rate of interest on money it lends to banks. If a high interest rate is charged, banks make fewer loans. This leads to a restriction in the inflation rate, because there is less money to go around so it becomes more valuable. If interest rates are lowered, more commerce is likely to happen. Interest rates often get a lot of media attention because it has such a direct effect on the lives of many people, especially when it comes to long-term loans such as mortgages. The Federal Reserve Board usually meets once a quarter to consider this.
Another method the Federal Reserve has for controlling the supply of money is by buying bonds. The money from these bonds is then put into the system in order for it to be used by banks. These banks will take charge, and attempt to lend the money out in order to realize a profit. This provides an engine for economic growth.
If the Federal Reserve wants to restrict the money supply, it can also sell bonds. This reduces the money for borrowing because the money that would normally be used for such purposes is used to buy the bonds the Federal Reserve is selling. Thus, the supply of money is tightened, which should control inflation but could also choke the economy, if done to too high a degree.
The final way the Federal Reserve can control the supply of money is through the requirements for reserves. Each bank, credit union or other depository institution is required to keep a certain amount of its money in reserves, defined as a certain percentage. The Federal Reserve can change the amount required for reserves, thus freeing up money or further restricting its use, depending on what the economic situation may call for.
