Central Banks and Money Supply

How Central Banks control the money supply?

The central bank determines the reserve ratio for banks in a country. smaller banks keep part of the deposit as reserves and use the remaining deposit as loans. Banks earn a profit on these loans. The money supply is of the following types.

M1: Currency, checkable deposits at bank, and traveler's checks.

M2: M1 + Savings and time deposits

M3: M2+Long term time deposits, CD's. 

In the US, the Feds buy US government bonds which are their asset. The federal reserve notes in circulation and deposits (M2) are on the Fed's liabilities.

Open Market Operations:

One way to influence the money supply is by increasing the money base (assuming keeping the reserve ratio the same). The central bank does this by buying more government bonds on the open market (aka OMO - Open Market Operations). When they buy bonds, the money is deposited in the bank accounts of the sellers. Banks will have money to give part out as loans. The money multiplier effect kicks in and increases the money supply. Similarly, selling bonds will reduce the money supply to prevent inflation. 

Reserve Requirement:

The Fed can also control the supply of money by its choice of the reserve requirement. Recall that the money multiplier is the reciprocal of the reserve requirement. If the Fed increases the reserve requirement, the money multiplier decreases, implying that deposit creation and the money supply are reduced. If the Fed decreases the reserve requirement, the money multiplier increases, causing both the creation of deposits and the money supply to expand further.