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This is what money supply growth may look like starting with 1 new dollar of deposits. The money is moving from left to right. The Central Bank buys a government bond from Bank 1 for $1, Bank 1 lends the proceeds to Person 1, who buy an asset from Person 2, who deposit the proceeds at Bank 2, who loans it to Person 3, who buys an asset from Person 4, who deposit the proceeds in Bank 1, and the money supply is $2.
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See for example the balance sheet from Citigroup Inc. at [3].
When the Fed is "easing", it increases the monetary base by purchasing Treasuries on the open market. When the Fed is "tightening", it reduces the monetary base by selling Treasuries on the open market. It reduce or increase the supply of short term government debt, and inversely increase or reduce the supply of currency.
The operative notion of easy money is that the Fed creates new bank reserves (also known as " federal funds", trades in the " money market"), which let the banks lend out more money. These loans get spent, and the proceeds get deposited at other banks. Whatever is not required to be held as reserves is then lent out again, and through the magic of the "money multiplier", loans and bank deposits go up by many times the initial injection of reserves.
However in the 1970s the reserve requrements on deposits started to fall with the emergence of money market funds, which require no reserves. Then in the early 1990s, reserve requirements were dropped to zero on savings deposits, CDs, and Eurocurrency deposits . At present, reserve requirements apply only to " transactions deposits" - essentially checking accounts. The vast majority of funding sources used by banks to create loans have nothing to do with bank reserves.
These days, commercial and industrial loans are financed by issuing large denomination CDs. Money market deposits are largely used to lend to corporations who issue short term commercial paper . Consumer loans are also made using savings deposits which are not subject to reserve requirements. These loans can be bunched into securities and sold to somebody else, taking them off of the bank's books.
The point is simple. Commercial, industrial and consumer loans no longer have any link to bank reserves. Since 1995, the volume of such loans has exploded, while bank reserves have declined.
In recent years, the irrelevance of " open market operations" has also been argued (for slightly different reasons) by academic economists renown for their work in the theory of “ rational expectations”, including Thomas Sargent and John Muth .
One of the principal jobs of central banks (such as the US Federal Reserve, the Bank of England and the European Central Bank) is to keep money supply growth in line with real GDP growth. Central banks do this primarily by applying pressure on the " federal funds" interest rate through open market operations.
A very common criticism of this policy, originating with the creators of GDP as a measure, is that "real GDP growth" is in fact meaningless, and since GDP can grow for many reasons including manmade disasters and crises, is not correlated with any known means of measuring well-being. This use of the GDP figures is considered by its own creators to be an abuse, and dangerous. The most common solution proposed by such critics is that money supply (which determines the value of all financial capital, ultimately, by diluting it) should be kept in line with some more ecological and social and human means of measuring well-being. In theory, money supply would expand when well-being is improving, and contract when well-being is decreasing, giving all parties in the economy a direct interest in improving well-being.
This argument must be balanced against the near- dogma among economists, that the control of inflation is the main (or only) job of a central bank, and that any introduction of non-financial means of measuring well-being has an inevitable domino effect of increasing government spending and diluting capital and the rewards of gainfully employing capital.
Currency integration is thought by some economists -- Robert Mundell, for example -- to alleviate this problem by ensuring that currencies become less competitive in the commodity markets, and that a wider political base be employed in the setting of currency and inflation and well-being policy. This thinking is in part the basis of the Euro currency integration in the European Union.
Money supply remains one of the most controversial aspects of economics itself.
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