Understanding How the Federal Reserve Creates Money

The Federal Reserve System is the central bank of the United States. Referred to as the Fed, it is arguably the most influential economic institution in the world. One of the chief responsibilities set out in the Fed’s charter is the management of the total outstanding supply of U.S. dollars and dollar substitutes. That means the Fed is responsible for the policies that create or destroy billions of dollars every day.

Despite being charged with managing the money supply, the modern Federal Reserve does not simply run new paper bills off of a machine. Of course, real currency printing does occur (with the help of the U.S. Department of the Treasury). However, the vast majority of the American money supply is digitally debited and credited to commercial banks. Moreover, real money creation takes place after the banks loan out those new balances to the broader economy.

How Does the Federal Reserve Work?

The Federal Open Market Committee (FOMC) and associated economic advisers meet regularly to assess the U.S. money supply and general economic conditions. If it’s determined that new money needs to be created, then the Fed targets the amount of money needed and institutes a corresponding policy to inject it into the economy.

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. 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 estimate the money supply.

How the Fed Increases the Money Supply

The Fed could initiate open market operations (OMO), where it buys or sells Treasuries to inject or absorb money. It can use repurchase agreements for temporary expansions. It can use the discount window for short-term loans to banks.

By far, the most common method of adding money is through 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 and deposit $1 billion of new money into the reserves of banks.

Types of 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.

Known as monetary aggregates, not all of the classifications above are widely used. Different countries may use different classifications. The money supply reflects the liquidity that each type of aggregate has in the economy. It is broken up into different categories of liquidity (or spendability).

Use of Monetary Aggregates

The Federal Reserve uses monetary 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 an accurate depiction of the actual size of the country’s working money supply. By reviewing weekly reports of M1 and M2 data, investors can measure the money aggregates’ rate of change and monetary velocity overall.

Understanding the Federal Funds Rate

The target federal funds rate is a suggested interest rate set by the FOMC based on its view of the country’s economic health. It’s used by banks as a guide for the interest rate to charge each other for overnight loans of excess reserves.

The fed funds rate is an important tool used by the Fed to influence other interest rates and affect the money supply. For instance, by lowering the rate, banks follow suit and lower the rates they charge on products such as consumer loans and credit cards.

Due to the severity of the COVID-19 pandemic and its negative effect on economic activity, in March 2020, the Fed Board reduced to zero the reserve requirement ratio banks must use. This eliminated the reserve requirement for all depository institutions.

Another Way the Fed Creates Money

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 released to the public (almost always through some favored government agency or politically-connected business).

Central banks have become much more technologically creative since then. The Fed figured out that money doesn’t have to be physically present to work in an exchange of money for goods and services. Businesses and consumers could use checks, debit and credit cards, balance transfers, and online transactions.

Money creation doesn’t have to be physical, either. It needn’t be printed. The country’s central bank can simply determine the new dollar balances needed and credit them to other accounts.

Today’s Federal Reserve buys new, readily liquefiable accounts, such as U.S. Treasuries, on the open market from financial institutions to add funds to their existing bank reserves.

This has the same effect as printing new bills and transporting them to the banks’ vaults (but it’s cheaper). The newly credited balances count just as much as physical bills in the economy. They can also be just as inflationary.

The Credit Market Funnel

Suppose the U.S. Treasury prints $10 billion in new bills. In addition, the Federal Reserve credits $90 billion in readily liquefiable accounts. At first, it might seem like the economy just received a monetary influx of $100 billion. However, that’s only a very small percentage of the potential total amount of money created.

This is because of the role of banks and other lending institutions that receive new money. Nearly all of that $100 billion enters banking reserves. Banks don’t just sit on the part of those funds that is excess reserves (although the Fed pays interest to encourage banks to keep them). Most of it is loaned out to governments, businesses, and private individuals.

The credit markets have become a funnel for money distribution. In a fractional reserve banking system, new loans actually create even more new money. Despite a legally required reserve ratio of, normally, 10%, the new $100 billion in bank reserves could potentially result in a nominal monetary increase of $1 trillion.

Fractional Reserve Banking and the Money Multiplier

As mentioned above, the country’s central bank creates monetary reserves by buying treasuries. It then sends the funds to the commercial banks on the other side of the transaction. Banks can then make loans with that money, up to the reserve requirement limit.

So, if the Fed issues $1 billion in reserves to a bank, then at a normal reserve ratio of 10%, the bank can lend $900 million to borrowers. These borrowers will deposit those funds back into the banking system. Down the line, people paid with the loaned money will also deposit funds they receive.

Now this money can be loaned out, in an amount up to the reserve limit. So, if that $900 million is deposited and then loaned out, an additional $810 million may be deposited. Ultimately, through this money multiplier effect, the $1 billion in reserves can turn into $10 billion in new credit money in the economy.

The Bottom Line

The Federal Reserve creates money when it decides that the economy would benefit by it doing so. It creates money not by printing currency but by effectively adding funds to the money supply.

The Fed does this in various ways, including changing the target fed funds rate with the goal of affecting other interest rates. Or it may buy Treasury securities on the open market to add funds to bank reserves. Banks create money by lending excess reserves to consumers and businesses. This, in turn, ultimately adds more to money in circulation as funds are deposited and loaned again.

The Fed does not actually print money. This is handled by the Treasury Department’s Bureau of Engraving and Printing. The U.S. Mint makes the country’s coins.