Afew weeks ago, I solicited FEE daily readers for their questions about economics. Pretty quickly I got a question I was pretty certain I’d get eventually. It comes from a man named Warren from Chicago who asks:
“what are the levers used by the Federal Reserve Bank to increase or decrease the money supply?
I know it has something to do with interest rates and bank reserves, but how does it actually take place and who receives all the extra money in circulation to cause the inflation?”
There are several channels that the Federal Reserve can use to create money, but I’m going to focus on the two most relevant ones: open market operations and interest on reserves.
‘Printing’ Money
The first way the Federal Reserve can increase the money supply is by creating more dollars. It’s not as simple as them printing dollar bills then throwing them out of a helicopter, though.
Instead, when the Federal Reserve wants to create money and put it into the system, it does so through banks. Banks hold several types of assets including treasury bonds. Treasury bonds are IOUs that the government issues in exchange for a loan. You buy a bond with cash today and the government promises to pay you back with interest in the future.
Banks like to hold treasury bonds because they’re viewed as low risk—it’s unlikely the US government will default on debt (any time soon at least). Treasury bonds also have the advantage that they’re relatively easy to sell to someone else to get cash. Economists call this ease of converting an asset into money liquidity.
The Federal Reserve offers to buy these bonds from banks. When the Federal Reserve buys bonds, they have an advantage you and I don’t. They are allowed to print new money to buy the bonds. It’s more likely that the money will be digitally created than literally printed, but the form of the money doesn’t make a difference.
The Federal Reserve acquires government bonds and banks acquire newly created money. The process doesn’t stop there, however. Banks don’t generally like to sit on large piles of money because money doesn’t earn interest (unlike the bonds they just sold to the central bank). So what do banks do with their money?
One thing they can do is make more loans to businesses. The increased supply of funds available to lend out means that there will be more loans available for the same number of businesses. Everything else held constant, this means the price of borrowing (the interest rate) will fall.
Banks can also turn around and buy more treasury bonds if they want to replace some of the bonds sold. This higher bond demand means the government will be able to take on more debt to finance its spending.
Economists call this process of the Federal Reserve using newly created money to buy bonds from private banks an open market purchase.
So how much has the Federal Reserve utilized this tool as of late? Look at this graph:
Figure 1: Treasury Securities Balances Held Outright
Since January 2020, The Federal Reserve has increased its treasury securities from $2.3 trillion to around $5.6 trillion today, an increase of around $3.3 trillion.
The Fed Moves into Housing
A more recent move by the Federal Reserve has been to purchase other types of assets as well. Before 2008, the Federal Reserve owned $0 in Mortgage-Backed Securities (MBSs). Today is a different story.
I won’t go into detail about MBSs (you can read more about them here) except to say they’re another type of financial asset banks hold which are a good bit riskier than treasury bonds. Here is a graph showing how Federal Reserve MBS holdings exploded in 2008 (in an attempt to alleviate the housing crisis) and again in 2020 (in an attempt to curb the negative effects of COVID policies).
fee.org/articles/how-does-the-federal-reserve-create-money/