Do you know how the Federal Reserve "pumps" money into the economy? Recently, the news media have reported that the Federal Reserve has "pumped" money into the economy, but they do not explain exactly how the Fed does this.

You might be wondering how this matters to you. The fact is that the more you understand how governments control money, the better you will be able to take control of your own economic situation, especially in a global economy. One of the primary functions of a government is to control the amount of money in the system.

Every nation has its own central bank. One of the functions of a central bank is to respond to current economic situations to either cool down or heat up the economy. In the United States, the central bank is the Federal Reserve.

Although the news media use this type of language, they don't explain exactly how the Fed increases or decreases the amount of money. What does the Fed do when the media report that the Fed is "pumping money" into the economy to calm fears of an economic panic? What does it do to "drain money" from the system, to cool it down?

Before we figure out what it means, let's establish clearly what it does NOT mean. The Fed does not pump money into the system by printing out more currency. Currency is not equivalent to money.

The Fed has several methods to control the amount of money in the system.

The first tool the Fed uses is to adjust the reserve requirement of banks. The "reserve" is the portion of customer deposits that the bank must keep. It cannot loan all of its deposits.

If you have ever wondered how banks make money, they make it by loaning out customers deposits to other customers. However, the bank cannot loan out all of its deposits. If you deposit $1,000 in the bank, the bank loans most, but not all, of your $1,000 to other customers.

The Federal Reserve sets the reserve requirements for banks. Typically, the reserve ranges from 3-10% of its deposits. So, with your $1,000 deposit, the bank needs to keep on reserve only $30 with a 3% reserve and $100 with a 10% reserve. The bank is free to loan out whatever is left after the reserve requirement. With a 3% reserve the bank can loan out $970 of your money. With a 10% reserve, the bank can loan out only $900.

If the Fed wants to increase the money supply, it can reduce the reserve rate. If the Fed wants to decrease the amount of money in the system, it increases the reserve requirements. This simple example demonstrates how the process works, and how the Fed pumps money into and drains money out of the system by changing the reserve requirements.

With a lower reserve requirement, the bank has more money to loan. With a higher reserve requirement, the bank has less money to loan. This is the difference between loaning out 97% of its deposits with a 3% reserve rate and 90% of its deposits with a 10% reserve rate. The changes in reserve rates increase and decrease the money supply.

It is a bit misleading to claim that the Fed "pumps" money into the system. In fact, the Fed allows the banks to "pump" more money into the system, because the Fed has reduced the reserve rate. The lower the rate, the more money the banks can pump into the system. The ability of the Fed to change reserve requirements is one powerful tool Fed uses to control the amount of money in the economy.