Understanding How the Federal Reserve Creates Money
Understanding How the Federal Reserve
Determining the Money Supply
The Federal Open Market Committee (FOMC) and associated economic advisers meet regularly to assess the U.S. money supply and general economic condition. If it is determined that new money needs to be created, then the Fed targets a certain level of money injection and institutes a corresponding policy.1
It’s hard to track the actual amount of money in the economy because many things can be defined as money. Obviously, paper bills and metal coins are money, and savings accounts and checking accounts represent direct and liquid money balances. Money market funds, short-term notes, and other reserves are also often counted. Nevertheless, the Fed can only approximate the money supply.
The Fed could initiate open market operations (OMO),
where it buys and sells Treasurys to inject or absorb money. It can use repurchase agreements for temporary expansions.2 It can use the discount window for short-term loans to banks. By far, the most common result is an increase in bank reserves. So, if the Fed wants to inject $1 billion into the economy, it can simply buy $1 billion worth of Treasury bonds in the market by creating $1 billion of new money.
The various types of money in the money supply are generally classified as Ms, such as M0, M1, M2 and M3, according to the type and size of the account in which the instrument is kept.3 Not all of the classifications are widely used, and each country may use different classifications. The money supply reflects the different types of liquidity each type of money has in the economy. It is broken up into different categories of liquidity (or spendability).
The Federal Reserve uses money aggregates as a metric for how open-market operations, such as trading in Treasury securities or changing the discount rate, affect the economy. Investors and economists observe the aggregates closely because they offer a more accurate depiction of the actual size of a country’s working money supply.3 By reviewing weekly reports of M1 and M2 data, investors can measure the money aggregates’ rate of change and monetary velocity overall.
Money Creation Mechanism
In the early days of central banking, money creation was a physical reality; new paper notes and new metallic coins would be crafted, imprinted with anti-fraud devices, and subsequently released to the public (almost always through some favored government agency or politically-connected business).
Central banks have since become much more technologically creative.
The Fed figured out that money doesn’t have to be physically present to work in an exchange. Businesses and consumers could use checks, debit and credit cards, balance transfers, and online transactions. Money creation doesn’t have to be physical, either; the central bank can simply imagine up new dollar balances and credit them to other accounts.
A modern Federal Reserve drafts new readily liquefiable accounts, such as U.S. Treasuries, and adds them to existing bank reserves. Normally, banks sell other monetary and financial assets to receive these funds.
This has the same effects as printing up new bills and transporting them to the bank vaults but it’s cheaper. It is just as inflationary, and the newly credited money balances count just as much as physical bills in the economy.
The Federal Reserve Bank must destroy currency when it is damaged or fails its standard of quality.
The Credit Market Funnel
Suppose the U.S. Treasury prints $10 billion in new bills, and the Federal Reserve credits an additional $90 billion in readily liquefiable accounts. At first, it might seem like the economy just received a monetary
influx of $100 billion, but that is only a very small percentage of the actual money creation.
This is because of the role of banks and other lending institutions that receive new money. Nearly all of that extra $100 billion enters banking reserves. Banks don’t just sit on all of that money, even though the Fed now pays them 0.25% interest to just park the money with the Fed Bank.2 Most of it is loaned out to governments, businesses, and private individuals.
The credit markets have become a funnel for money distribution. However, in a fractional reserve banking system, new loans actually create even more new money. With a legally required reserve ratio of 10%,
the new $100 billion in bank reserves could potentially result in a nominal monetary increase of $1 trillion.4
Fractional Reserve Banking and the Money Multiplier
In the modern banking system, the central bank creates monetary reserves and sends those to commercial banks. Banks can then lend much of that money, up to a certain limit known as the reserve requirement—which has been around 10% in the U.S.4
So, if the Fed issues $1 billion in reserves to a bank, it can then lend $900 million to borrowers. These borrowers will then ultimately deposit those funds back to the banking systems (either directly or indirectly from people paid with the loaned money), which can then be loaned out at 90%—so if that $900 million is deposited, an additional $810 million may be deposited. Ultimately, through this money multiplier effect, the $1 billion in reserves will turn into $10 billion in new credit money in the economy.