Tornado Alley (PROG)

[SilverSurfer]

Let's say that, on a certain day, the Fed buys $4 billion dollars worth of Treasury bonds from a particular dealer. To do so, the Fed takes possession of the bonds (electronically) and puts $4 billion in the dealer's bank account. The dealer's bank now has $4 billion more to loan out, which, in the way I have described above, creates a lot of new money. Thus, by buying bonds, the Fed has increased the money supply of the country.

Now, let's say that, a month later, the Fed wants to decrease the money supply, so they sell $4 billion worth of bonds to a particular dealer. To do so, they credit the dealer with possession of the bonds and take $4 billion out of the dealer's bank account. The dealer's bank now has $4 billion less to loan out, which decreases the money supply.

At this point, you are probably wondering, where does the Fed get all the money to buy and sell such large quantities of Treasury bonds? The answer is — and this is the coolest part of all — they don't really have the money; they just make it up.

-- if your bank were to credit your account with a million dollars, you would, all of a sudden, have an extra million dollars to spend? One reason why your bank doesn't do this is that banks can't just go around giving people money out of nothing. If your bank wants to credit your account with money, that money has to come from somewhere.

The Fed is a different type of bank. They are allowed to credit accounts without having to come up with real money. Thus, when the Fed puts a $4 billion credit in the bank account of a bond dealer, the money doesn't have to come from anywhere. The mere fact that the Fed puts it in a bank account is enough to create the money. Similarly, when the Fed takes $4 billion out of a bank account, the money doesn't go anywhere. It just ceases to exist.

Does this mean that, if the Federal Reserve wanted to, it could credit your bank account with a million dollars without causing a bookkeeping problem? Absolutely.
http://www.harley.com/money/the-fed-and-money-part-i.html