The Fed directly impacts the money supply, which only consists of cash, checks and credit. This indirectly affects liquidity by raising or lowering interest rates.
Tools of Monetary PolicyThe Fed's five major tools are all based around managing banks' reserves. First, the Fed sets a reserve requirement,which tells banks how much of their money they must have on reserve each night. If it weren't for the reserve requirement, banks would lend 100% of the money you've deposited. Not everyone needs all their money each day, so it is safe for the banks to lend most of it out.
However, the Fed requires that banks (on average) keep 10% of the money deposited on reserve. That way, they have enough cash on hand to meet most demands for redemption. When the Fed wants to restrict liquidity, it raises the reserve requirement. Since it's difficult to ask banks to change this, the Fed only does this as last resort.
Second, the Fed can easily manage banks' reserves with the Fed funds rate. This is the interest rate that banks charge each other to store their excess cash overnight. The target for this rate is set at the eight Federal Open Market Committee (FOMC) meetings. The Fed funds rate impacts all other interest rates, including bank loan rates and mortgage rates.
Third, the FOMC usually sets the central bank's discount rate, which is what it charges banks to borrow funds from the Fed's fourth tool, the discount window. The discount rate is usually a percentage of a point higher than the Fed funds rate.
Fifth, the Fed uses open market operations to buy and sell Treasuries and other securities from its member banks. This changes the amount of reserves banks actually have on hand to lend, without changing the reserve requirement. The Fed created many new tools to deal with the Great Recession. To find out more, see Federal Reserve Tools.
Contractionary Monetary PolicyThe Fed's primary mandate is to manage inflation. It can reduce inflation by raising the Fed funds rate, selling securities through its open market operations or other measures to reduce liquidity. The Fed doesn't worry about inflation until it reaches its target of 2% (for the core inflation rate). For more, see contractionary monetary policy.
Expansionary Monetary PolicyThe Fed takes the opposite actions to lower unemployment and avoid recession. In this case, the Fed lowers the Fed funds rate, buys bank securities and otherwise increase the liquidity. For more, see Expansionary Monetary Policy.
Monetary Policy vs Fiscal policyIdeally, monetary policy should work hand in glove with the Federal government's fiscal policy. However, it rarely works this way. That's because elected officials get re-elected for spending tax dollars, or reducing taxes, on Federal programs that reward voters and campaign contributors (to put it quite bluntly). As a result, fiscal policy is usually expansionary. To avoid inflation, monetary policy must be a little contractionary.
Oddly enough, during the Great Recession, politicians became concerned about the U.S. debt, which had exceeded the benchmark debt-to-GDP ratio. As a result, fiscal policy became contractionary just when it needed to be expansionary. To compensate, the Fed needed to continue its expansionary monetary policy through 2013. Article update July 19, 2013