How the Fed Creates Money (out of thin air)

U.S. Federal Reserve sealHow does money get created in the U.S.? Primarily by the Federal Reserve and Bureau of Engraving and Printing (BEP). The BEP produces our coins and paper money which is about 3% of the total money in circulation. Where is the other 97%? In banks as credit and debit entries.

What is the Federal Reserve?

The Federal Reserve is the central banking system for the United States. It was created in 1913 to mitigate bank runs and financial panics.

Who owns the Federal Reserve?

Not the government. It is privately owned by the twelve Federal Reserve banks.

Monetizing the Debt

Instead of Congress creating money by printing it (and paying no interest) it has to ask the FOMC (the Fed) for money and pay interest on it. The money borrowed adds to the Federal Debt. The interest is financed by Treasury bills (or notes or bonds depending on the duration). The Federal Debt is *not* paid back; only the interest is serviced.

Here is the process for Congress to get money for its projects:

  1. Congress (the govt) wants 100M
  2. Federal Bureau of Engraving (FBE) prints 100M of money (Fed reserve notes) and gives it to the Federal Open Market Committee (FOMC)
  3. FOMC gives it to govt
  4. The govt creates 100M in bonds and gives it to FOMC. The govt has to pay interest on the money it wanted
  5. The bonds go to the 12 Fed Reserve banks. (Look at a dollar bill and you'll see a stamp of one of them A-L)
  6. The interest payments go to the 12 banks

Banks don't need to have reserves before making loans because the Fed will provide the necessary reserves at low interest rates (the federal funds rate). Note I did not say free. Banks borrow from the Fed at low interest rates and lend at higher interest rates.

The loan is recorded as a deposit in the bank (i.e. the and a liability (since it is lent out). So the reserve requirement is not changed.

When the borrower actually spends the money it is transferred out of the bank to other banks where it is a deposit. Then the bank replenishes its reserves by borrowing from the Fed. Now the banks that receive the loan money can lend it out again and again.

One way to Expand the Money Supply

To expand the money means the Fed wants to create money and add it to what is available.

  1. Security dealers have government bonds available for sale to the public
  2. The Fed purchases 100M of these bonds
  3. The Fed creates 100M in its bank account via an accounting entry
  4. The Fed pays the dealers by transferring the 100M to their bank accounts

Conclusion

As you can see, every time Congress wants money, they pay interest on it. Remember the $3 billion dollars for the cash-for-clunkers program? It was financed and we will be paying interest on the $3 billion for a long time (depending on which Treasury notes were used). If it was 30 year, the $3 billion dollar program will end up costing around $6 billion dollars.

BTW, the Federal Debt stood at $11.9 Trillion dollars as of Oct 2009.

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