Here is a greatly simplified explanation.

 

The money supply does not equal the wealth of the nation.  Total net worth of the United States (real net worth in resources, property, buildings, infrastructure, etc.) is at least $45 trillion.  However, the M1 money supply is currently $1.7 trillion, and M2 is $7.8 trillion.  Therefore - there isn't enough "current money" to balance with assets.

 

Normally this isn't an issue as people don't expect to hold their net worth in their hands as "cash".  However - since cash is what drives economic exchange it is very important for real time, current economic activity.  There are some very good books on monetary theory if you want to think about alternatives to the Austrian view - a good place to start is Milton Friedman and Anna Schwartz Amazon.com: A Monetary History of the United States, 1867-1960 ... but the bottom line is the value of money is related to both its quantity and its velocity (rate of movement) through an economy.  Money's value drops as either the quantity or velocity rises - and it rises as either the quantity or velocity falls.

 

When people start to hoard cash, velocity can drop rapidly - since their are few buyers of commodities, goods or services, (low demand), prices begin to fall.  That is what is currently happening - on Friday, even gold and other precious metals dropped in price.  Oil is dropping, farm commodities are dropping - everything is dropping - which means the value of the dollar is rising.  This is good for those of us who hold cash - but it isn't so good for those who want to remain employed.

 

Anyway, now for the simple explanation regarding what the Fed and Treasury are doing ...

 

Normally, people would be loaning their money directly to private enterprises - either through savings accounts in banks, or through "money market funds" like Vanguard's Prime Money Market.  This goes for other instruments, such as corporate bonds, etc.  Now that people aren't sure those securities are safe, they are rapidly pulling their money out of private funds - even gold funds aren't considered secure right now.

 

Where are they "fleeing" to for security?  The United States Treasury - I would never have thought the Treasury would have been able to sell their securities, but it seems they have an almost unlimited market right now.  So - dollars are fleeing the private sector, for the perceived "security" of the United States Treasury.

 

What does Treasury do with their excess dollars?   They "deposit" them with the Federal Reserve banks.  These dollars then become the "monetary base" - and the Federal Reserve can create 10 dollars from every dollar the Treasury deposits due to the fractional reserve system.

 

So - what has the Fed started doing?  Since the people are afraid to loan their money out for even very secure purposes, the Federal Reserve System is now providing those loans.  All of those private sector companies that are having to return dollars back to individual investors (who then send them to the Treasury) are now going direct to the Federal Reserve System to get those dollars back in order to maintain operations.

 

Thus - dollars are "destroyed" when people pull them out of the private sector system and deposit them with Treasury - and Treasury issues Treasury securities - but then they are "recreated" by Treasury deposits with the Federal Reserve - who is then issuing loans to the private sector to maintain liquidity.

 

Instead of investor to private sector demand, it is now investor to Treasury to Fed to private sector demand.

 

In this way the money really hasn't disappeared from the system (or contracted due to loss of velocity, as happened from 1929 through 1933), the Treasury and Fed are functioning properly to back the financial system through their actions.

 

Now - how does all that money being issued by the Fed get pulled back out of the economy?  Well - the process reverses.  People begin to gain confidence in the private sector again, they start lending directly to the private sector.  In doing so they pull funds back from Treasury securities - which removes their deposits from the Federal Reserve Banks.  Fortunately, the private sector reduces their cash demand on the Federal Reserve Banks as their demand is met directly by the investors, and the process reverses and unwinds itself.

 

This is a simplified explanation of how it works, codify - and timing is everything, the system isn't perfect.  This means you can expect mistakes and volatility - but over the next 6 months to a year we ought to see that Bernanke's actions will prevent massive bank failures as were seen from 1929 to 1933.  This will do much to confirm the theories of monetary economics developed in the last 75 to 80 years - and it will provide a huge amount of data for economic graduate students for decades.

 

Of course - if what the monetary theorists thought they learned from The Great Depression isn't right, and Bernanke is taking the wrong actions, then it won't work.

 

I hope Bernanke and the monetary economists are right.  We'll know in the coming months.