A bank's ability to provide loans

 A bank's ability to provide loans is limited by only 2 things:

• the amount of its deposits and
• its reserve requirements. 

The reserve requirements are determined by the central bank or monetary authority.

Most banks are required to put a minimum percentage of their funds - 10% of deposits, for example - on reserve and are prohibited from lending these funds back to customers.

If a central bank increases the reserve requirement, it effectively reduces the money supply, since banks then have less to lend to businesses and consumers.

On the other hand, by reducing the reserve requirements - as several central banks around the world did during the Great Recession of 2008 - they allow the country's banks to lend more, stimulating the economy and releasing even more money for lending.

The main tool for fighting uncontrolled inflation: reduce the money supply

The main tool for fighting uncontrolled inflation is for the government and local monetary authorities to reduce the money supply.

Since most easily accessed money is in the form of bank deposits, the most efficient way for a central bank to control the money supply is by regulating 

• bank lending and 
• reserve requirements.

Essentially, when banks have more money to lend to customers, the economy grows  And when banks reduce their lending the economy slows.

The reason central bank monetary policy works so well is because of the multiplier effect.

How do central banks inject money into the economy?

Investment Question
How do central banks inject money into the economy?

Central banks use several different methods to increase (or decrease) the amount of money in the banking system. These actions are referred to as monetary policy. While the Federal Reserve Board (the Fed) could print paper currency at its discretion in an effort to increase the amount of money in the economy, this is not the measure used.

Here are three methods the Fed uses in order to inject (or withdraw) money from the economy:

1. The Fed can influence the money supply by modifying reserve requirements, which is the amount of funds banks must hold against deposits in bank accounts. By lowering the reserve requirements, banks are able loan more money, which increases the overall supply of money in the economy. Conversely, by raising the banks' reserve requirements, the Fed is able to decrease the size of the money supply.
2. The Fed can also alter the money supply by changing short-term interest rates. By lowering (or raising) the discount rate that banks pay on short-term loans from the Federal Reserve Bank, the Fed is able to effectively increase (or decrease) the liquidity of money. Lower rates increase the money supply and boost economic activity; however, decreases in interest rates fuel inflation, so the Fed must be careful not to lower interest rates too much for too long.
3. Finally, the Fed can affect the money supply by conducting open market operations, which affects the federal funds rate. In open operations, the Fed buys and sells government securities in the open market. If the Fed wants to increase the money supply, it buys government bonds. This supplies the securities dealers who sell the bonds with cash, increasing the overall money supply. Conversely, if the Fed wants to decrease the money supply, it sells bonds from its account, thus taking in cash and removing money from the economic system.

To learn more about central banks and their role in monetary policy, check out Formulating Monetary Policy.

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