Issues of The Regional Economist, published by the Federal Reserve Bank of St. Louis, may feature the section “Ask an Economist,” in which one of the Bank’s economists answers a question. The answer below was provided by Economist Emeritus Daniel Thornton.
The Fed controls the supply of money by increasing or decreasing the monetary base. The monetary base is related to the size of the Fed's balance sheet; specifically, it is currency in circulation plus the deposit balances that depository institutions hold with the Federal Reserve. The Fed has essentially complete control over the size of the monetary base.
The primary way the Fed controls the monetary base is through open market operations: buying or selling securities. To increase the monetary base, the Fed buys securities from any party and pays with a check. That check, written on the Fed, is deposited by a bank in its account with the Fed, thereby adding to its reserves and increasing the monetary base. The same process works for decreasing the monetary base: The Fed sells securities, getting a check from a bank in exchange. When the check is deposited, the bank's balance at the Fed decreases.
The total supply of money (M1) consists of currency held by the public and checkable deposit balances of banks and other depository institutions. The money supply and the monetary base are linked by reserves, i.e., vault cash and deposit balances held at Federal Reserve banks. While the Fed's control over the size of the monetary base is complete, its control over the money supply is not. One major reason for this is banks can choose to hold the additional base money (i.e., deposit balances with the Federal Reserve banks) supplied by the Fed as excess reserves.