During the history of the Federal Reserve it has been our policy to change the countries money supply by traditionally purchasing government bonds to increase the money supply or sell government bonds to decrease money supply. When the Federal Reserve purchases government bonds this naturally causes an increase in the money that is available to the nation's banks giving them more opportunity to make loans. This also has the tendency to lower interest rates which increases investment spending and overall increases the GDP. On the other hand when the Federal Reserve sells government bonds this will decrease the money supply available to banks lowering the amount of loans they are available to give. This will have the tendency to increase interest rates which decreases investment spending and overall decreases the GDP (O'Sullivan-Sheffrin, 2006).
An example of how this increase works is as follows. If the Federal Reserve buys government bonds the money that is put into the account of the purchaser will grow from its original amount. If the Federal Reserve buys the bonds for 1 million dollars the bank will maintain a certain percentage in reserve liabilities which depending on the banks net deposits will range currently from 3% to 10% (Federal Reserve Board). For this example we will use 10%, so the bank must keep $100,000 in reserve but the rest may be loaned out or used by the account holder. This money may branch off to numerous other banks these banks will also take out what percentage must be held in reserve liabilities and use the rest. This chain will continue and in each situation it will increase the money supply by a smaller percentage in each situation.
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