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Changes in the Fed’s monetary policies can help an economy to expand or contract by increasing or reducing the supply of money in the economy. A greater supply of money leads to more borrowing. More borrowing leads to more purchasing both by consumers and by businesses looking to expand. The opposite is true of contractionary policies.
The Fed can manipulate the money supply in a number of ways. It can raise or lower the required reserve ratio for banks. Such changes raise or lower the amount of money that banks can lend. This is the least common or important tool the Fed has to use. The Fed can also raise or lower interest rates. Higher interest rates reduce the amount of borrowing in an economy while lower interest rates tend to (all other things being equal) increase borrowing. Finally, there is the Fed’s most important tool. This is called “open market operations.” This tool allows the Fed to raise or lower the money supply by buying or selling government securities.
With all these tools, what the Fed is doing is changing the size of the money supply. Changes in the money supply will make borrowing easier or harder, leading to expansion or contraction of the economy, respectively.
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