First, after evaluating the state of the economy, the Fed determines whether the money supply needs to increase or decrease and by how much.
Second, if the Fed wants to increase the money supply it buys U.S. Treasury securities through open market operations and if it wants to decrease the money supply it sells securities.
Third, the act of buying or selling Treasury securities causes a change in bank reserves. If the Fed buys, then bank reserves increase. If the Fed sells, then bank reserves decrease.
Fourth, the change in reserves induces banks to change its lending activity. With more reserves, banks are willing to make more loans. With fewer reserves, banks are willing to make fewer loans.
Fifth, the change in bank lending affects the creation of checkable deposits, which are an important component of the money supply. More loans mean more deposits and an increase in the money supply. Fewer loans mean fewer deposits and a decrease in the money supply.
Sixth, the change in bank lending also affects interest rates. If banks are willing to lend more, then interest rates fall. If banks are willing to lend less, then interest rates rise.
