1. Congress issues US treasury bonds and is bought by banks.
2. New money bills are printed when the Fed buys treasury bonds from commercial banks. This new money is called High Powered Money (as this can be used for money multiplier effect). New bills are printed by the Treasury and they will ask "treasury bonds" as collateral from the Fed before printing.
3. Commercial bank uses this new money bills to issue loans in the reserve ratio (e.g 9:1). For $10000 of high powered money, bank issues a loan of $9000 and gets in return an IOU of $9000+interest
4. This IOU of $9000+I is an asset to the bank and can be used for further lending in the ratio of 9:1. Bank can issue another loan of $8100 and gets in return an IOU of $8100 + interest. Note that since the original printed currency was only $10000 from Fed, this new money being lent is out is from 'thin air' and is created by crediting the bank account of the person looking for loan.
5. Above lending process will continue so long as people are looking for loans and debt. All new money is created from debt. If no one comes for further loans, no new money is created
6. In the above process the total money supply created is equal to the the amount of debt = $9000 + $8100. However, the bank is expecting an IOU return of $9000 + $8100 + Interest. As a result of the Interest differential, there will always be some foreclosures in the economy and perpetual debt. To return this interest to the bank, more people will be asking for loans and hence more debt would be created (in turn creating more money supply)
7. To control the amount of foreclosures in the economy, it is the responsibility of the Fed to ensure that adequate high powered money is available. If banks are not loaning out money, the Fed can issue new bills to the bank (called quantitative easing) to increase lending and money supply. Alternatively if banks are lending too much money, Fed can purchase these bills back from banks and destroy these bills reducing the money supply. They can also control this through increasing the reserve ratio.
8. For the above model to work, it is extremely important that money supply is in balance with the amount of goods in the economy. If there are more goods in the economy and less money to buy, it will cause a depression. Hence the govt would reduce the reserve ratio or issue more high powered money. If there are less goods in the economy, govt would reduce money supply to prevent inflation.
