How Do Central Banks Work?

When the economy is hurting, it's often because the money supply is low. One way to counter this is by simply increasing the amount of money, or liquidity , that is present in the economy. Conversely, if the economy is growing too fast (a sign of bad inflation to come) decreasing the money supply is often the Fed's solution. Economists refer to increasing the money supply as "expansionary policy," while decreasing it is known as "contractionary policy."

And the Fed has been pretty successful, according to Tim Gindling, a professor of economics at the University of Maryland, Baltimore County. Gindling says, "Since the Great Depression, the Federal Reserve has done a good job using their control over the supply of money to stabilize the economy. The most clear evidence of this is that we have not had a depression since the 1930s."

Believe it or not, though, there's more to controlling the money supply than hitting the start button on those machines that print greenbacks. Here's how they go about it.

How Central Banks Control the Money Supply

Methods used by central banks to control the money supply can vary a bit from country to country, depending on the powers that are vested in the central banks. Here in the U.S., there are three main ways that the Federal Reserve is able to alter the money supply:

• Reserve requirements
• Interest rates
• Open market operations

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