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Because of the important link between money and the levels of income, employment, and prices, all modern governments exercise some degree of control over their system of financial institutions. In the United States, these controls began taking their modern form with the creation of the Federal Reserve System in 1913. (Willis & Hom, 2002, p. 363)The Federal Reserve Bank (Fed) acts as a central bank in the United States and is responsible for monetary policy. The Federal Reserve is an independent agency that does not take orders from the Congress or the president, so that the monetary policy is independent of the legislature and the White House.

The main tools that the Fed uses to control money supply and see the effect it has on the economy are the spread between the discount rate (DR) and the federal funds rate (FFR), the required reserve ratio and the open market operations (OMO).

Spread between the discount rate and Federal funds rate. The two interest rates that Fed is setting are the Federal funds rate (FFR) and the discount rate (DR). FFR is the rate at which banks and other depository institutions lend money to each other overnight. The DR is the interest rate that a bank or other eligible depository institutions are charged to borrow short-term funds directly from the Federal Reserve Bank.

A decrease in the DR increases the spread between DR and FFR so banks are inclined to borrow from the Fed instead of other banks. As banks borrow more money from Fed, more deposits enter the system and the supply of money increases. However, if the spread is positive (DR above FFR), banks will borrow from other banks and there will be no effect on the money supply.

The most powerful tool which the Fed can employ to affect the supply of money is that it can change the required reserve ratio (RRR), the percentage of reserves against deposits that banks are required to maintain.

If the Fed decreases the RRR, banks are required to hold lesser amount as reserve so the banks will have more available reserve to lend out, increasing money supply in the economy. If the Fed will increase the RRR, it will decrease the money supply on the system, since banks will have fewer available reserves to lend out and will have to hold more deposits to meet the requirement.

Open market operations (OMO) are the most significant of the Fed's tools for controlling the money supply. These operations involve buying and selling existing government securities (Treasury bills, bonds and other Federal instruments) in the market. Investors typically transact these instruments through auctions.

When the Fed buys these instruments, more money is released into the system, hence increasing money supply. On the other hand, when the Fed sells bonds, it takes funds out of the system, reducing reserves and the money supply.

In the previous section were presented the tools that the Fed is using to control money supply. Going further, the paper will present how money supply affects the macroeconomic indicators: real gross domestic product (GDP), interest rates, inflation rate and unemployment rate.

Real GDP is the amount of all final goods and services produced within a country, valued at base year prices. Real GDP as a goal depends on policies aimed to control inflation. Sustained economic growth is one of the major goals of macroeconomic policy. The United States has grown over the last century about 2% per year in real GDP/capita, the most common measure of the standard of living.

Real GDP increases with increasing the supply of money. "Higher levels of money in the system act as a spur for both investment and industrial consumer demand. This in turn, increases the nation's real GDP" (University of Phoenix, 2007). On the other hand, any measure taken by the Fed to drain money out of the system will lower the investments and spending in general and will lower the real GDP.

 The annual interest payments on a loan expressed as a percentage of the loan defines the interest rates. Using its tools to control money, Federal Reserve can influence also the interest rates. Suppose that interest rates are too high and the Fed want to lower them to encourage economy to expand. In order to lower the rates, the Fed increases the money supply. With an excess supply of money, investments increase, leading to an increase in real income and prices. This results in new lower interest rates so the money market is at a new equilibrium. Similarly, the Fed can increase the interest rates when decreases money supply by selling government securities on the open market, raising the discount rate for a positive DR-FFR spread and by raising the required reserve ratio.

Inflation is a rise in the general level of prices that affects the value of money. By increasing the supply of money, the Fed will increase the rate of inflation. By increasing the amount of money supply, the nominal value of money remains the same, however, the real value decreases since there is more money for the same amount of goods and service. The new money supply will be absorbed in the system, resulting in a higher price level and a corresponding lower value of money. As a result, the inflation rates will go up. To keep the inflation rate low, the Fed should lower the money supply on the market.

Unemployment rate is the key measure of economic health that is widely reported and watched for signs of change. Usually unemployment increases in business downturns, so, to improve the unemployment rate the Fed should increase the money supply. As a result, investments will increase and so the demand for workforce and employment opportunities. As these go up, the unemployment rate tends to come down. Similarly, when the Fed drains money out of the system, the real GDP falls, employment opportunities tend to fall, pressuring upward the unemployment rate. The unemployment rate in inversely related to the real GDP, therefore, when the real GDP goes up, the unemployment rate falls and when the real GDP rises, the unemployment rate goes down. . .

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