Modern money in almost all economies is fiat money controlled by a central bank and backed in law by a government.
The monetary objective of the central bank should be to maintain the value of the currency at a level beneficial to the political domain it is attached to and possibly the world, keeping inflation down etc. It does this through lending, borrowing and open market operations as described below.
The central bank does not as such posses a limited amount of money in its own currency. It can print or burn its own currency as it determines necessary. However there are rules about how currency leaves or enters a central bank which if not followed can lead to failing monetary objectives and possible collapse of the currency.
The central bank has a balance sheet and any money it creates "out of thin air" is marked as a liability on that balance sheet. Against this are its assets, foreign currency reserves, gold and what it is owed by the government and other banks.
Swap/trade foreign currency, gold or other financial assets, in its reserves. (These are called open market operations.) The central bank may also buy and sell financial instruments such as bonds, shares, foreign currencies etc. or precious metals for money, thus also changing the amount of narrow money in the economy. This is known as open market operations.
Trade government bonds, these are promises the government will pay the owner of the bond at a future date. The government sells bonds as a way of borrowing money.
Lend money to or hold deposits for other banks at interest rates it determines. (Holding deposits could be considered to be money borrowed from other banks.) The central bank may lend the money to the other banks and charge interest on those loans at a rate it determines. Other banks may also put money into the central bank and receive interest according to their deposits.
Regulating and supervising the banking industry.
Any money issued by the central bank to other institutions is either handed out physically as coins and notes (cash) or credited to the other institution's account at the central bank and convertible to coins and notes. Similarly any money returned to the central bank is either handed in physically as coins and notes or debited from the other institution's account at the central bank.
pays interest on institutional accounts that are in credit at rates it determines.
sells bonds in particular government bonds.
charges interest on institutional accounts that are in debt at rates it determines.
The central bank borrows ends money in a number of ways at varying interest rates one of which is publicised as the base rate.
The central bank controls the narrow money supply by setting the interest rates and by open market operations.
Money goes out of the bank in three ways, as loans (i.e. mostly bond purchases) as interest payments and for purchases in open market operations.
Money comes into the bank in three ways, as repayments, as interest receipts and for sales in open market operations.
The primary type of institutions dealing with the central bank are the other banks. The other banks may lend money to each other and to people, and charge interest on those loans and people may deposit money with those other banks and receive interest.
People that have borrowed money may spend that money and the people that receive it may in turn, deposit the money in the bank and receive interest for it.
1/(1-X) determines the amount of broad money in the economy, known as the broad money supply, as a multiple of the amount of narrow money. So if the reserve requirement was 20% then the amount of broad money can be as much as 5 times the amount of narrow money. If the reserve requirement was 10% then the amount of broad money is 10 times the amount of narrow money.
The central bank may limit the broad money in the economy by setting the reserve requirements for other banks. However the central bank can only control lending but cannot control whether the lending is responsible or not that is the duty of other banks.
Another limit on other bank lending is capital adequacy. The bank is required to hold capital assets with a risk adjusted value of X% of its total liabilities.
This is on top of the fractional reserve above. These assets can be sold if necessary to pay off liabilities i.e. pay people back who have put money in the bank.
Ultimately the price of borrowing, usually expressed as the interest rate is determined by the offers to lend and the bids to borrow in the market. However one player, the central bank, can always lend below the market price or borrow above the market price because it does not have a limited amount of money in its account.
When it lends below the market price then it undercuts lenders and may cause a surplus of borrowed money in the economy. Money will be borrowed from the central bank, faster than it is lent to the central bank. Interest payments will remove un-borrowed money from the economy.
When it borrows above the market price it overcuts borrowers and may cause a shortage of lent money in the economy. Money will be lent to the central bank, faster than it is borrowed from the central bank. Interest payments will add un-borrowed money to the economy.
There will always be a fraction of the narrow money which is borrowed from the central bank and a fraction which is not. This may have little influence, in that broad money borrowed from the other banks is a far larger proportion of the total money supply.
When money is borrowed from the central bank it makes more money available temporarily but then even less money available in the future when the money is paid back with interest. This may cause inflation then deflation.
consumable value - the economy may have a temporary reduction in prices for these types of consumable.
capital value - the economy may have a permanent reduction in prices for these types of capital asset.
Deflation is a problem for those in debt.
When money is lent to the central bank it makes less money available temporarily but then even more money available in the future when the money is paid back with interest. This may cause deflation then inflation.
Inflation is a problem for those in credit.
This subject is dealt with fully here but summarised below.
Prices are raised due to competition amongst buyers and lowered due to competition amongst sellers. It is the things on offer for sale and the money in bids to buy that will directly determine price. These are connected but not necessarily determined by the total money supply and the amount of tradable things in the economy as a whole.
Market shortages or market surpluses can be created when prices resist market conditions otherwise they are corrected by inflation or deflation.
Central banks strive to meet inflation targets by controlling the money supply through setting interest rates, open market operations and setting reserve requirements.
They can control the money supply but they cannot control the things on offer for sale and the money in bids to buy that will directly determine price, and thus inflation, they can only influence it.