Have you seen the news reports that the Federal Reserve has "pumped" money into the economy? Have you wondered exactly what that means? How exactly does the Fed "pump" more money into the system?

One of the fundamental functions of government is to control the money supply. The more you understand how governments control the amount of money in the economic system, in a global economy, the better you can take control of your own personal economic system.

Every nation has a central bank. In the United States, the central bank is the Federal Reserve. The central banks pay attention to the condition of the current economic conditions, and then take actions to either heat up or cool down the economy.

You might hear that the Fed is "pumping money" into the economy to calm fears of an economic panic. At other times, you will hear that the Fed will "drain money" from the system, to cool it down. Although the news media uses such language, they don't explain exactly how the Fed increases or decreases the amount of money.

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 can control the money supply with several methods.

One method is to change the reserve requirements of banks. The "reserve" is the percentage of customer deposits that the bank must not loan out. In other words, a bank must keep a certain percentage of its deposits on "reserve."

Banks make money by loaning out customer deposits to other customer deposits. This means that if you deposit $1,000 in the bank, the bank loans most of your money to other customers. However, the bank is not allowed to loan out the full $1,000.

The Federal Reserve requires banks to keep on reserve 3-10% of its deposits, and allows the banks to loan the rest. In the case of your $1,000, this means that the bank needs to keep only 3-10% of your $1,000 on reserve. With a 3% reserve, the bank must keep only $30 on reserve, and is allowed to loan out the remaining $970. With a 10% reserve, the bank must keep $100 on reserve and is allowed to loan out only $900.

This example demonstrates that the Fed can control the amount of money banks can loan by changing the how much the banks must keep on reserve. When the Fed wants to "pump" money into the system, it reduces the reserve requirements. The same process works in the opposite direction. The Fed can "drain" money from the system if it increases the reserve requirements.

When the bank has to keep 10% of its deposits on reserve, it can loan out only 90% of its deposits. When the bank has to keep only 3% of its deposits on reserve, it can loan out 97% of its deposits to customers. With a lower reserve, more money is available. With a higher reserve, less money is available. .

So even though the media talk about the Fed "pumping" more money into the economy, this language is a bit misleading. The banks do the "money-pumping" when the Fed allows banks to loan out a higher percentage of its deposits. This is one way the Fed controls the amount of money in the economic system.

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