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.

In the United States, the central bank is the Fed, or Federal Reserve. Every nation has an equivalent central bank. These banks monitor current economic conditions and respond if the central banks want to heat up or cool down the economy.

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?

First, it's important to be clear what it does NOT mean. The Fed does not pump more money into the system by printing more currency. Currency is not equivalent to money.

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

One method involves the reserve requirements for banks. A bank must keep a portion of its deposits on reserve. In other words, the bank can only loan out a percentage of its deposits as loans. The percentage it cannot loan out is the reserve.

If you deposit $1,000 in the bank, the bank makes money by loaning out most of your $1,000 to other customers. However, the bank cannot loan the full $1,000 amount.

The Federal Reserve sets the reserve requirements for banks. The banks must keep 3-10% of customer deposits on reserve. This means that the bank needs to keep on reserve only 3-10% of your $1,000. With a 10% reserve, the bank must keep $100 on reserve. That means it can loan out the remaining $900. With a 3% reserve, the bank must keep only $30 on reserve. It is allowed to loan out the remaining $970.

The Fed can use the reserve requirements to control the amount of money banks have available to loan. If the Fed wants to increase the amount of money in the economy, it reduces the reserve requirements. If it wants to decrease the amount of money, it increases reserve requirements. This is how the Fed "pumps" money into the system and "drains" money from the system.

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. .

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.