A Bit of Background on Banking
The banking system makes it possible for the Fed to change the money supply. So before we look at how the Fed implements monetary policy, some background on the banking system is in order.
Banks in the United States, like banks everywhere, practice what is known as fractional reserve banking. Fractional reserve banking emerged when early bankers realized that only a small percentage of deposits would be withdrawn on a given day. For instance, if the bank had total deposits of $10 million, perhaps the most they would see withdrawn on a given day would be $1 million.
This would leave the bank with $9 million available to lend to borrowers. (Commercial and savings banks take deposits and loan them out at a higher ...