A reader writes:

Once the Fed Prints/Creates money, where does it go? Is it handed out to all Banks? Or just made available to loan? The later seems ridiculous today given how much money is already in circulation. Just have no idea who gets this money or where it goes once it is created.

This is something that is confusing for many people. And even I get lost in the topic when I try to explain it. Many years ago, the Federal Reserve actually printed a 40 page or so booklet that explained this process in great detail. It’s no longer in circulation, but you can find it online in various forms. It’s called Modern Money Mechanics. I actually keep a copy on my bedside table, no joke. That’s because it is confusing. I made my first attempt to explain this process on the premise of “How The Federal Government Prints Money”. Today I want to try to retell this story from a different perspective.

This time, I just want to talk about how the Fed creates money. But first a little back-story. The Federal Reserve is charged with maintaining banking stability, limiting inflation, and minimizing unemployment. Their primary tool has always been interest rates. Basically, they set an interest rate that banks can borrow from them at. This interest rate influences all other interest rates, from your mortgage to a giant corporation’s hundred million dollar line of credit. The Fed expects that when they raise interest rates, people will save more and borrow less. Likewise, when interest rates are low people borrow more and save less. For the most part this program works. The exception is usually in extreme conditions, such as this most recent recession.

So the Fed has other tricks up it’s sleeve. One of them is to control the money supply. If low interest rates aren’t having an impact, the Fed may inject money directly into the economy through a process called “open market operations”. In its simplest form, all the Fed is doing is buying assets from banks. It could be US Treasury bonds, or terribly toxic mortgages. They usually buy bonds (see my original post) but they can buy anything a bank is willing to sell. And this operation is done with banks. The idea is simple, banks have investments. Some of those investments are US bonds, some are mortgages, and others fall into other categories. Naturally, a bank can only invest so much. If they have $100 in deposits, then they can invest $100*.

Much of this investment is in the form of mortgages. So let’s say all the banks are maxed out. They’re all fully invested, and because the economy is suffering they’re not getting new deposits from their customers. They’re basically stuck. And if the investments they hold suck, the bank is in danger of going under. In this circumstance, interest rates won’t do much for anyone. The Fed to raise rates to encourage saving, but it discourages borrowing. So a bank may get more money to loan, but people won’t want to borrow.

So the Fed may use the “open market operations” tool to free up money in the economy. Basically, the Fed will buy some investments from the bank. So say the Fed buys $10 in bad loans from our bank. That bank now has $10 it can lend out to the economy. The Fed has been doing this for a couple of years now by purchasing government bonds from the banks and toxic mortgages. The estimates are the Fed has purchased more than $1,000,000,000,000 in mortgages. That’s a trillion dollars.

As I said before, when the Fed makes the purchase they’re exchanging cash for an asset from the bank. The banks gets the cash, and the Fed gets the asset. But where did the Fed get the cash from? Well, essentially, it was created out of thin air. It’s an electronic transaction so the Fed’s computer basically tells the bank’s computer to increase they’re lendable money by the $10 the Fed bought the assets for. Now the bank can lend out that $10 which puts the money directly into the economy.

This sounds bad, but this is how our economy has been based for a long time. And it’s no different than any other developed economy around the world. Right now, it’s the best thing we’ve got to make an economy work. For the most part it does. But the manipulation of interest rates and injection of cash into the economy must be watched closely. The more money printing the Fed does, the more we debase our currency. This can have two effects on us. The first is an increase in inflation. With more money out there chasing the same amount of goods, prices naturally rise. The other issue is our dollar is devalued relative to the rest of the world. $10 five years ago may sound the same as $10 right now, but on a global scale it’s not. That would have bought you 8 euros worth of goods in Europe, but now only buys 7. Sounds small to you, but what that means is anything we buy oversees becomes more expensive too.

It’s not all bad, a devalued currency also draws attention for foreign investment. A cheap dollar means our goods look more desirable overseas.

So to answer the question in just one or two lines: the Fed buys assets from the bank, and then the bank can lend it out or invest, and that’s how we put it in the economy.

And it does sound ridiculous considering how much is already in the economy. But the problem is a lot of the money the Fed has injected into the economy is just sitting there. Some banks deposit it with the Fed, while others are just buying US bonds and collecting the small interest rate. Inflation will be a concern, but not until the economy starts borrowing and spending again. Once that happens the Fed will shift gears and actually sell those assets they bought (sometimes for a profit) which has the opposite effect and removes money from the economy.

It sounds confusing, but I challenge you to get educated before you start down the path of moving us back to gold or dissolving the Fed. Read as much as you can about the system. In at least my experience, the fractional reserve system (which is what we have) is the most stable economic support system we currently know about.

Some other day we’ll talk about how that $10 can actually turn itself into $90, which is the real way the Fed creates money. But today this is enough to absorb.

Photo: cliff1066

*For those of you in the know, I’m trying to avoid adding confusion by excluding the reserve requirement and multiplier effect

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categories: banking, economics, government