The Federal Reserve increases the money supply four ways: it buys U.S. government securities on the open market, lowers the interest rates it administers, adjusts the reserve requirements banks must hold, and, in a crisis, runs large-scale asset purchases known as quantitative easing. Each tool works by putting more reserves into the banking system so banks can lend more, and lending is what actually creates new dollars in the economy. Which tool the Fed reaches for depends on how much stimulus the economy needs.
Congress gave the Fed a dual mandate — maximum employment and stable prices — and the Federal Open Market Committee (FOMC) targets 2 percent annual inflation on the personal consumption expenditures index as its measure of price stability.1Federal Reserve. Why Does the Federal Reserve Aim for Inflation of 2 Percent Over the Longer Run? When unemployment rises or inflation drops below that target, the Fed expands the money supply to lower borrowing costs and encourage spending.2Federal Reserve. What Economic Goals Does the Federal Reserve Seek to Achieve Through Its Monetary Policy?
Buying Government Securities on the Open Market
Open market operations are the Fed’s most frequently used tool. Section 14 of the Federal Reserve Act authorizes the transactions, and a federal regulation requires every Federal Reserve Bank to carry them out as directed by the FOMC.3eCFR. 12 CFR Part 270 – Open Market Operations of Federal Reserve Banks
To add money, the Fed buys Treasury bonds and notes. It doesn’t buy from individual investors. It transacts with a set of large banks and broker-dealers called primary dealers, which the Federal Reserve Bank of New York has approved as counterparties for monetary policy operations.4Federal Reserve Bank of New York. Primary Dealers When the Fed buys a bond from a dealer, it pays by crediting the dealer’s bank with newly created reserves at the Fed. The dealer’s bank now holds more reserves than it needs and has fresh capacity to lend.
Those loans are where new dollars actually enter the economy. A bank that receives fresh reserves can lend to homebuyers, small businesses, or corporations, and each loan creates a new deposit in the borrower’s account. The FOMC scales purchases up when it wants to push more money into the system and reverses course — selling securities or letting them mature — when it wants to pull money out.
Lowering Interest Rates
The federal funds rate is what banks charge each other for overnight loans of reserves. The FOMC doesn’t set it directly; it announces a target range and uses its other tools to keep the actual rate inside that range. As of January 2026, the target range is 3‑1/2 to 3‑3/4 percent.5Federal Reserve. Federal Reserve Issues FOMC Statement – January 28, 2026 When the FOMC lowers this target, borrowing becomes cheaper across the economy, which encourages lending and expands the money supply.
Two administered rates do the actual work of keeping the federal funds rate inside the target range.
The first is Interest on Reserve Balances (IORB), the rate the Fed pays banks on money they keep deposited at the central bank. It currently stands at 3.65 percent.6Federal Reserve. Implementation Note Issued January 28, 2026 Because banks can earn IORB risk-free, they generally won’t lend reserves to another bank for less. IORB acts as a floor under overnight rates. Lower the IORB, and parking money at the Fed becomes less attractive, which pushes banks to lend those funds instead.
The second is the discount rate, the rate the Fed charges banks that borrow directly from it through the discount window. Section 10B of the Federal Reserve Act authorizes these short-term loans.7Federal Reserve. Section 10B – Advances to Individual Member Banks The primary credit rate — available to banks in sound financial condition — is currently 3.75 percent, with a higher secondary credit rate for banks that don’t qualify.8Federal Reserve. H.15 – Selected Interest Rates (Daily) The discount rate acts as a ceiling: banks won’t pay each other more than it costs to borrow directly from the Fed. Lowering it makes reserves cheaper to obtain and supports more lending.
Adjusting Reserve Requirements
Reserve requirements historically forced banks to hold a set percentage of their deposits in reserve instead of lending them out. Regulation D, at 12 CFR Part 204, gives the Fed authority to set those ratios for monetary policy purposes.9eCFR. 12 CFR Part 204 – Reserve Requirements of Depository Institutions (Regulation D) Lower the ratio and banks can lend more; raise it and they lend less.
This tool is not currently active. On March 15, 2020, the Federal Reserve Board reduced all reserve requirement ratios to zero percent, effective March 26, 2020, eliminating the requirement for every depository institution in the country. That single change freed roughly $200 billion in reserves that banks had been required to hold idle.10Federal Reserve. Reserve Requirements As of 2026, the ratio remains at zero. The Fed now steers bank behavior through interest rates, particularly IORB, rather than mandated reserve ratios. If you’re reading older explanations that describe the Fed lowering reserve requirements as a routine expansion move, that mechanism is no longer in use.
Quantitative Easing
When the economy is in severe distress and the federal funds rate is already near zero, standard rate cuts lose their punch. You can’t make borrowing much cheaper when rates are already at the floor. In those conditions, the Fed turns to quantitative easing: large-scale purchases of long-term securities that go well beyond routine open market operations.
Instead of buying only short-term Treasury bills to manage overnight rates, the Fed buys long-term Treasury bonds and mortgage-backed securities in large quantities. The goal is to push down long-term interest rates in specific credit markets, such as the mortgage market, that short-term rate cuts cannot reach.11Federal Reserve Board. How the Federal Reserve’s Large-Scale Asset Purchases (LSAPs) Influence Mortgage-Backed Securities (MBS) Yields and U.S. Mortgage Rates These purchases inject huge volumes of cash into the accounts of the banks and institutional investors that sell the securities, giving them far more capital to deploy through loans and investments.
The scale can be striking. The first round of QE, which began in late 2008, involved roughly $1.25 trillion in mortgage-backed securities and about $175 billion in agency debt. A second round in late 2010 added another $600 billion in longer-term Treasury purchases. Even after years of subsequent reductions, the Fed’s balance sheet held about $6.6 trillion in total assets as of February 2026.
Risks of Quantitative Easing
QE is powerful but carries real risks. The Congressional Budget Office has flagged several:12Congressional Budget Office. How the Federal Reserve’s Quantitative Easing Affects the Federal Budget
- Interest rate sensitivity. The Fed’s purchased assets pay fixed interest, but the reserves it created to buy them carry variable interest costs. That mismatch makes the government’s total borrowing costs more vulnerable to rising rates.
- Potential Fed losses. If rates rise sharply, the Fed can end up paying more in interest on reserves than it earns on its holdings, producing periods where expenses exceed income.
- Inflation risk. If QE continues while the economy is already running above its potential, the extra money is more likely to push prices up than to generate real growth.
- Financial market instability. Both the expansion and the eventual unwinding can disrupt markets. Balance-sheet reduction contributed to a spike in overnight lending rates in the fall of 2019 when reserves became unexpectedly scarce.
Why These Tools Actually Add Money
All four tools rely on the same underlying mechanic. When a bank makes a loan, it doesn’t hand over cash from a vault. It credits the borrower’s account with new funds, creating a deposit that didn’t exist a moment earlier. That deposit is new money in the economy. When the borrower spends it, the funds land in someone else’s account, where they can support further lending.
Each dollar the Fed injects through open market operations or QE can therefore support a much larger total increase in the money supply. How much larger depends on how willing banks are to lend and how willing borrowers are to take on debt, not just on how much the Fed puts in. In a healthy economy, that multiplying effect amplifies the Fed’s actions. In a downturn, banks may sit on extra reserves rather than lend them out, which is why the Fed sometimes has to move past ordinary rate cuts and use quantitative easing to get money flowing.