Harley Hahn - Economics Explained - How the U.S. Federal Reserve Creates and Destroys Money

Money and
Economics

How the U.S. Federal Reserve
Creates and Destroys Money

(February 26, 2012)

Summary: In order to manipulate the money supply, the U.S. Federal Reserve (the central bank of the United States) routinely creates and destroys large amounts of money. They do so indirectly, by buying and selling large volumes of bonds.

The central bank of the United States, the U.S. FEDERAL RESERVE, is overseen by a Board of Governors (three woman and two men), who do their best to maintain the money supply at the level they think is best for the economy. To do so, they regularly create or destroy money large sums of money, sometimes as much as several billion dollars a day.

This suggests an interesting question: How does someone create several billion dollars? For that matter, how does someone destroy a billion dollars?

The manipulations carried out by the Federal Reserve (often referred to as the "Fed") are based on the fact that a large percentage of the money supply is created from bank deposits. Thus, in order to increase or decrease the money supply, all the Fed has to do is increase or decrease bank deposits. Here is how it works.

Most of the money deposited in banks is not actually kept by the bank. In fact, it is loaned out. When this happens, more money is now available to be spent, which has the effect of increasing the money supply of the country. For example, let's say Person A deposits $100 in a bank, which means he has $100 he can spend. In accordance with Federal Reserve regulations, the bank is allowed to loan up to 90% of this money to someone else, say, Person B.

Once Person B has $90 in his bank account, this makes a total of $190 available to be spent. But his bank can loan up to $81 (90% of $90) to someone else. Now a total of $271 is available to be spent. And so on. In this way, the dollars that are deposited in a bank will, eventually, end up creating many more dollars in circulating money.

The Federal Reserve can increase the country's money supply simply by increasing bank deposits.

What this means is that the Federal Reserve can increase the country's money supply simply by increasing bank deposits. Conversely, they can decrease the money supply by decreasing bank deposits. They do so, indirectly, by buying and selling bonds. Because bonds are so important, I'd like to digress for a moment to explain how they work.

A BOND is a debt issued by a company, government or government agency in order to borrow money for a specific amount of time. To obtain the money, borrowers make two promises. First, they promise to make regular interest payments. Second, they promise to pay back the original sum of money after the specified amount of time has passed. In other words, a bond is a type of IOU.

Here is a typical example: the XYZ Company wants to borrow $10 million for 10 years, and they are willing to pay 5% interest a year, with payments every 6 months. (Most bonds pay interest every 6 months.) It will be difficult for them to find one person or one company willing to loan them the entire $10 million, so, instead, they will sell 400 bonds for $25,000 apiece.

Let's take a moment to figure out the interest. The XYZ Company has promised to pay 5% a year. For a $25,000 bond, this means $1,250 a year ($1,250 = 5% of $25,000). Since the payments must be made every 6 months, the XYZ Company will need to make regular payments of $625 (half of $1,250).

You decide to buy one of these bonds, so you give the XYZ Company $25,000. In return, they agree to pay you $625 in interest every 6 months for 10 years. At the end of the 10 years, the XYZ Company will pay you back the $25,000. From the company's point of view, the bond is a way for them to borrow money at a fixed cost for a specific amount of time. From your point of view, the bond is an investment that provides you with predictable income for 10 years.

Who sells bonds? Any organization that wants to borrow money for a specific amount of time. For example, a city might issue bonds in order to pay for a new high school.

Who buys bonds? People, companies, and governments that want a guaranteed rate of return on their investments. For example, many retired people buy bonds and live off the interest. Similarly, companies and governments often buy bonds to earn income from their surplus funds.

No doubt, you have heard that the U.S. government borrows a huge amount of money. It does so by having the U.S. Treasury issue various types of bonds. To borrow money for a short amount of time (defined as 1 year or less), the Treasury issues what are called TREASURY BILLS. To borrow money for a medium length of time (between 1 and 10 years), they issue TREASURY NOTES. To borrow money for a long period of time (over 10 years), they issue TREASURY BONDS. For our purposes, we can consider them more or less the same, so I'll refer to all of them as Treasury bonds.

In case you are wondering how much money the U.S. Government owes, as of the day I am writing this (February 24, 2012) the federal debt is over $15.4 trillion, to be precise, $15,416,323,644,046.76. (What I want to know is, what's the 76 cents for?)

You might be wondering, how fast does this debt grow? The first time I wrote about this topic (May 24, 2001), the federal debt was a bit over $5.6 trillion. The last time I wrote about this topic (June 21, 2009), the federal debt was about $11.4 trillion. If you do the arithmetic, you will see that the U.S. debt has increased about 270 percent in 11 years, and about 75 percent over the last 2.7 years.

What does this have to do with banks and the Fed?

As I explained, new money is created when banks loan out money that has been deposited with them. The reason the Fed can manipulate the system is that only money in the form of cash can be loaned out. Money in the form of bonds cannot be loaned out. Since bond money stays where it is, it does not circulate and, hence, does not increase the money supply.

Thus, it is possible for the Federal Reserve to control the size of the money supply by controlling how much money the banks keep in cash (which is loanable) compared to how much money they keep in bonds (which is not loanable). To increase the money supply, the Fed moves money from bonds into cash. To decrease the money supply, the Fed moves money from cash to bonds. The details are complex, but the basic idea is that each day, the Fed buys (or sells) several billion dollars worth of U.S. Treasury bonds from (or to) certain financial companies who act as dealers.

Let's say that, on a certain day, the Fed wants to increase the money supply. To do so, they buy, say, $4 billion dollars worth of Treasury bonds from a particular dealer. In effect, they take possession of the bonds (electronically) and put $4 billion into the dealer's bank account. The dealer's bank now has $4 billion more to loan out, which, in the way I have described above, ends up creating a lot of new money.

Now, let's say that, a month later, the Fed wants to decrease the money supply, so they sell $4 billion worth of bonds to a particular dealer. To do so, they credit the dealer with possession of the bonds and take $4 billion out of the dealer's bank account. The dealer's bank now has $4 billion less to loan out, which decreases the money supply.

Where does the Fed get all the money to buy and sell such large quantities of Treasury bonds? They just make it up.

At this point, you are probably wondering, where does the Fed get all the money to buy and sell such large quantities of Treasury bonds? The answer is — and this is the coolest part of all — they don't really have the money; they just make it up.

Consider this following pleasant idea. If your bank were to credit your account with a million dollars, you would, all of a sudden, have an extra million dollars to spend. One reason why your bank doesn't do this is that banks can't just go around giving people money out of nothing. If your bank wants to credit your account with money, that money has to come from somewhere.

The Fed, however, is a different type of bank. It is allowed to credit accounts without having to come up with real money. Thus, when the Fed puts a $4 billion credit in the bank account of a bond dealer, the money doesn't have to come from anywhere. The mere fact that the Fed puts it in a bank account is enough to create the money. Similarly, when the Fed takes $4 billion out of a bank account, the money doesn't go anywhere. It just ceases to exist. And that is the key that makes the whole thing work.

Does this mean that, if the Federal Reserve wanted to, it could credit your bank account with a million dollars without causing a bookkeeping problem? Absolutely. The trick, of course, is to get them to want to do so.

If you'd like to try, their phone number is (202) 452-3000. Ask for Mr. Bernanke.