The Fed was originally created to stabilize the workings of the money and credit markets. In reality, it is the reason why our money is worth less and less everyday. As it stands today, market participants hang on to every word of the Fed Chairman because a single statement can literally reverse the stock market trend.

The Fed controls the money supply by selling or buying securities to the major banks. How does the Fed buy these securities? With simply the stroke of a pen, it literally creates money out of thin air - this isn't a joke.

Let us assume that the Fed decides to 'loosen' its monetary policy. It does so by buying securities from the banks (essentially, a large briefcase of paper money is deposited). This deposit of paper money becomes part of that particular bank's assets. When the bank's assets increase, it is able to loan out additional credit in accordance to the legislated reserve ratios that vary from 8-12%. Reserve requirements were passed as part of the Monetary Control Act of 1980 and must be adhered to by all depository institutions in the United States. Thus, if we assume that the ratio is 10%, and $1 billion dollars of newly created securities are deposited, that bank may now loan out $10 billion.

When the Fed 'tightens' its monetary policy, it does so buy selling securities (essentially, taking the large briefcase of paper money away). When it does this the bank must call in loans in order to adhere to the required reserve ratio. This may result in the bank being legally unable to give out any loans until it achieves the reserve ratio target.