NCPA - National Center for Policy Analysis


February 28, 2008

Signs of an economic slowdown have prompted the Federal Reserve to lower interest rates.  The Fed reduces interest rates by increasing the supply of money available to borrow.  This additional money is distributed to banks and loaned to consumers.  Assuming a constant demand for money, an increase in the quantity of money will cause interest rates to drop.  But how does the Fed increase the money supply, asks Bob McTeer, a distinguished fellow and Pamela Villarreal, a policy analyst with the National Center for Policy Analysis.

First, consider what happens when you, as an individual, borrow money.  Suppose you go to the bank and obtain a loan:

  • The bank gets a new asset (your note) and a new liability (additional funds in your checking account).
  • You have new money to spend, and the balance in your checking account, which is part of the nation's money supply, is raised by the amount of the deposit.

Unlike your bank, the Fed can create new bank reserves as well as money.  The primary way the Fed does so is by buying and selling U.S. Treasury securities on the open market.  For example: 

  • When the Fed buys $10 million of Treasury bills on the open market, it credits the selling banks' reserve accounts for $10 million.
  • Since the reserves didn't come from another bank, one could say they were created out of "thin air."
  • The initial expansion of deposits and reserves will lead to an expansion of 10 times $10 million because each dollar of reserves will support roughly 10 times that amount in deposits.

The key difference between the Fed's ability to create money and any individual bank's ability to do so is that since almost all banks have accounts at the Fed, new Fed lending does not lead to a loss of funds from the banking system, explain McTeer and Villarreal. 

Source: Bob McTeer and Pamela Villarreal, "How the Fed Creates Money," National Center for Policy Analysis, Brief Analysis No. 611, February 28, 2008.

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