Monetary Policy of The United States - Money Creation

Money Creation

Currently, the US government maintains over US$800 billion in cash money (primarily Federal Reserve Notes) in circulation throughout the world, up from a sum of less than $30 billion in 1959. Below is an outline of the process which is currently used to control the amount of money in the economy. The amount of money in circulation generally increases to accommodate money demanded by the growth of the country's production. The process of money creation usually goes as follows:

1. Banks go through their daily transactions. Of the total money deposited at banks, significant and predictable proportions often remain deposited, and may be referred to as "core deposits." Banks use the bulk of "non-moving" money (their stable or "core" deposit base) by loaning it out. Banks have a legal obligation to keep a certain fraction of bank deposit money on-hand at all times.
2. In order to raise additional money to cover excess spending, Congress increases the size of the National Debt by issuing securities typically in the form of a Treasury Bond (see Treasury security). It offers the Treasury security for sale, and someone pays cash to the government in exchange. Banks are often the purchasers of these securities, and these securities currently play a crucial role in the process.
3. The 12-person Federal Open Market Committee, which consists of the heads of the Federal Reserve System (the seven Federal governors and five bank presidents), meets eight times a year to determine how they would like to influence the economy. They create a plan called the country's "monetary policy" which sets targets for things such as interest rates.
4. Every business day, the Federal Reserve System engages in Open market operations. If the Federal Reserve wants to increase the money supply, it will buy securities (such as U.S. Treasury Bonds) anonymously from banks in exchange for dollars. If the Federal Reserve wants to decrease the money supply, it will sell securities to the banks in exchange for dollars, taking those dollars out of circulation. When the Federal Reserve makes a purchase, it credits the seller's reserve account (with the Federal Reserve). The money that it deposits into the seller's account is not transferred from any existing funds, therefore it is at this point that the Federal Reserve has created High-powered money.
5. By means of open market operations, the Federal Reserve affects the free reserves of commercial banks in the country. Anna Schwartz explains that "if the Federal Reserve increases reserves, a single bank can make loans up to the amount of its excess reserves, creating an equal amount of deposits".
6. Since banks have more free reserves, they may loan out the money, because holding the money would amount to accepting the cost of foregone interest When a loan is granted, a person is generally granted the money by adding to the balance on their bank account.
7. This is how the Federal Reserve's high-powered money is multiplied into a larger amount of broad money, through bank loans; as written in a particular case study, "as banks increase or decrease loans, the nation's (broad) money supply increases or decreases." Once granted these additional funds, the recipient has the option to withdraw physical currency (dollar bills and coins) from the bank, which will reduce the amount of money available for further on-lending (and money creation) in the banking system.
8. In many cases, account-holders will request cash withdrawals, so banks must keep a supply of cash handy. When they believe they need more cash than they have on hand, banks can make requests for cash with the Federal Reserve. In turn, the Federal Reserve examines these requests and places an order for printed money with the US Treasury Department. The Treasury Department sends these requests to the Bureau of Engraving and Printing (to make dollar bills) and the Bureau of the Mint (to stamp the coins).
9. The U.S. Treasury sells this newly printed money to the Federal Reserve for the cost of printing. This is about 6 cents per bill for any denomination. Aside from printing costs, the Federal Reserve must pledge collateral (typically government securities such as Treasury bonds) to put new money, which does not replace old notes, into circulation. This printed cash can then be distributed to banks, as needed.

Though the Federal Reserve authorizes and distributes the currency printed by the Treasury (the primary component of the narrow monetary base), the broad money supply is primarily created by commercial banks through the money multiplier mechanism. One textbook summarizes the process as follows:

"The Fed" controls the money supply in the United States by controlling the amount of loans made by commercial banks. New loans are usually in the form of increased checking account balances, and since checkable deposits are part of the money supply, the money supply increases when new loans are made ...

This type of money is convertible into cash when depositors request cash withdrawals, which will require banks to limit or reduce their lending. The vast majority of the broad money supply throughout the world represents current outstanding loans of banks to various debtors. A very small amount of U.S. currency still exists as "United States Notes", which have no meaningful economic difference from Federal Reserve notes in their usage, although they departed significantly in their method of issuance into circulation. The currency distributed by the Federal Reserve has been given the official designation of "Federal Reserve Notes."