Money supply and the Fed's Actions

Many of you elected to use the December 18 article titled "Japan Looks Set to Follow U.S. Rate Cut". Several of you had difficulty conceptualizing the mechanism of the money supply. As stated by a class participant:

The article mentions that as part of the “quantitative easing” approach, the Fed may consider buying U.S. Treasuries to create funding for new programs. I am not clear how the U.S. federal government purchasing its own securities provides additional funding in a real sense.

To clarify this issue I will guide you through the following steps:
1. Economic activity is promoted by banks extending credit
2. When credit is granted by a bank, it create a "deposit" available to the borrower for check writing.
3. Banks are limited by reserve requirements (stipulated by the Fed) as to how much credit they can extend. Currently, for every 10 dollars in deposits the bank must hold a reserve of one dollar. The more the reserves available to a bank the more deposits (and hence credit) it can create.
4. When the Fed buys securities from dealers, it pays them money that is automatically deposited in their bank accounts.
5. This extra money constitutes new (and therefore additional)reserves that enable banks to lend more (see point 3 above) by creating new loans (deposits).
6. Because bank deposits constitute a component of the money supply, we say that by purchasing securities the Fed helps increase the money supply or the quantity of money.
7. Note that if banks refuse to use the new reserves to grant new loans (as they currently do) , the money supply may not grow.