The Fed has the ability to control the level of bank intermediation (which is just the amount of bank lending and money creating).

Two of the tools that the Fed has available to control level of bank intermediation is its open market operations and reserve requirements. 

Required reserves must be held in the form of a deposit maintained with a Federal Reserve Bank. An institution that is a member of the Federal Reserve System must hold the deposit directly with a Reserve Bank, whereas an institution which is not a member of the system can maintain that deposit directly with a Reserve Bank or with another institution in a pass-through relationship.

Each Federal Reserve Bank in acts in effect as a banker to commercial banks in its districts.

The Fed must still constantly increase the amount of currency in circulation because as an economy expands more currency is needed by the public for ordinary transactions.

The most important tool of the Fed is its open market operations. Open market operations are purchases and sales of government securities which allows the Fed to create and reduce member bank reserves.

When the Fed buys government securities, its purchases inevitably increase bank reserves by an amount equal to the cost of the securities purchased.

Even if the source of the government securities purchased by the Fed is nonbank, the result will still be essentially the same since the money received by the seller will be inevitably deposited in a commercial bank.

In the case of sales of government securities by the Fed the process described above operates exactly in reverse and member bank reserves are eliminated.

Suppose the Fed were to require banks to hold 10% of total deposits. If the Fed were then to create, $90 billion of bank reserves, the maximum deposits banks could create through intermediation would be $900 billion.

Therefore, with a 10% reserve ratio, every $1 billion of government security purchases by the Fed would permit a $10 billion increase in bank assets and liabilities, whereas $1 billion of sales would do the opposite.

Open market operations are a powerful tool for controlling the level of bank activity, and they are used daily by the Fed to do so.

The founders of the Fed viewed discounting as its key tool. However, in practice things have worked out differently. Over time the Fed has switched from controlling member bank reserve through discounting to controlling them through open market operations. Open market operations are preferred to discounting for 2 main reasons:

1.      Puts Fed in the position of being able to take the initiative 

2.      Size + liquidity of market for government securities are such that the Fed can make substantial purchases and sales without disrupting the market or causing more than negligible price changes

The discount window still exists, and bank borrow there. This activity creates some slack in the Fed’s control over bank reserves, so the Fed has to limit borrowing at the window. One way the Fed does this is through charging a high penalty rate on discounts. This discourages banks from borrowing except in cases of real and temporary need. The Fed began charging a penalty in 2003 when it changed the rules surrounding discount borrowing, which meant that banks could no longer profit by borrowing at the discount window and lending elsewhere.

Today, borrowing at the discount represents a small element of the total reserves available to member banks. Daily borrowing per day was just $42 million in 2004 compared to $1 billion per day during the period of 1975 to 1990.

Banks borrow and lend excess reserves to one another in the federal funds market. The rate at which such lending and borrowing occurs is called the fed funds rate. When the Fed cuts back on the growth of bank reserves, this tightens the supply of reserves available to the banking system relative to its demand for them, this in turn drives up the fed funds rate, which in turn then drives up other short term interest rates.

This means that any easing or tightening by the Fed necessarily alters not only money supply growth but interest rates as well. The Fed cannot have two independent policies, one to control money supply growth and a second to influence interest rates.

In open market operations the Fed purchases government securities through the creation of new money.

Over the years the Fed has varied its modus operandi for its implementation of monetary policy, switching between reserve-targeting regimes and interest-rate targeting regimes, settling on interest-rate targeting in the late 1980s. In an interest-rate targeting regime, the Fed essentially forgoes its control over the money supply.

Today the Fed sees its major policy job as pursuing countercyclical monetary policy. Which means applying monetary restraint when the economy is growing too strong and providing accommodation when it is growing at an undesirably slow pace. The Fed’s main tool in this respect in the Fed’s open market operations.