Final answer:
The Federal Reserve increases the money supply by buying government bonds, which injects more money into the banking system, allowing banks to increase lending.
Step-by-step explanation:
To increase the money supply, the Federal Reserve can utilize different monetary policy tools. According to how the banking system interacts with the Federal Reserve, money supply is increased when the Federal Reserve buys government bonds. This process involves the central bank creating money and using it to purchase bonds from individual banks. The money paid to the banks increases their reserves, which they can then use to make more loans and thus increase the money circulating in the economy. In contrast, when the Federal Reserve sells government bonds, it is receiving money from the banks for those bonds, effectively reducing the amount of money that the banks have available to lend out, thereby decreasing the money supply in circulation.
To carry out an expansionary monetary policy—which aims to increase the money supply and stimulate economic activity—the Fed will buy bonds. This leads to a decrease in interest rates, which can stimulate investment and consumption, and can also affect the exchange rate in a way that can boost net exports. Conversely, a contractionary monetary policy, which aims to reduce inflation and cool down an overheated economy, would involve the Fed selling bonds to decrease the money supply and increase interest rates.