In the US, a single institution holds tremendous power over the affairs of the whole country’s currency supply – the Federal Reserve. Commonly known as the Fed, this central bank is tasked with an array of crucial responsibilities, with one of its primary roles being the careful management of the nation’s total outstanding supply of US dollars and their substitutes. To fully understand this process, let’s dive into the inner workings of the Federal Reserve and understand how it creates and controls the money, revealing a process that extends far beyond the mere printing of physical bills.
Federal Reserve: Goals and Functions
The Federal Reserve functions as the central banking system of the United States. Its primary duty involves managing the total supply of US dollars and dollar substitutes. This entails implementing policies that create or eliminate billions of dollars daily.
While the process of physically printing currency does occur with the assistance of the US Department of the Treasury, the majority of the American money supply exists in digital form. Commercial banks play a crucial role in money creation by loaning out new balances to the wider economy.
The Federal Reserve’s goals and functions include:
- Monetary policy. The Fed develops and executes monetary policies to maintain price stability and encourage maximum employment. It uses various instruments, such as interest rate adjustments and managing the money supply, to influence economic conditions and control inflation.
- Supervision and regulation. The Fed controls banks and other financial institutions to ensure the stability and reliability of the banking system. It establishes and enforces regulations that safeguard consumers, preserve the integrity of the financial system, and mitigate systemic risks.
- Financial system stability. Safeguarding the overall stability of the financial system is a vital responsibility of the Federal Reserve. It monitors and assesses potential risks and vulnerabilities in financial markets, takes necessary actions to address them, and acts as a lender of last resort during times of financial strain.
- Currency issuance. The Federal Reserve is tasked with issuing and managing the nation’s currency, including the production, distribution, and destruction of paper currency and coins. Its goal is to preserve integrity and public trust in the US dollar as a reliable medium of exchange.
- Economic research and analysis. Conducting economic research and analysis is a key function of the Federal Reserve. Through such efforts, it gains insights into the state of the economy, assesses risks, and informs its policy decisions. The Fed publishes reports, economic forecasts, and research papers that contribute to the understanding of monetary and economic matters.
- Financial services to banks and government. These services include offering loans to banks, maintaining reserves for depository institutions, managing the federal funds rate (the interest rate at which banks lend to each other on a short-term basis), and overseeing the US Treasury’s accounts.
The Federal Reserve’s money creation mechanism primarily involves the addition of credit to banks’ deposits rather than the physical printing of cash. This credit resembles the kind you receive when your employer directly deposits your paycheck into your bank account.
Guiding monetary policy is the responsibility of the Federal Open Market Committee (FOMC), which serves as the operational arm of the Fed. When the Fed expands credit, it engages in expansive monetary policy and increases the available money supply for borrowing, spending, or investing. This expansion of credit is instrumental in ending recessions. To implement monetary policy, the Fed often relies on the federal funds rate.
When the Federal Reserve wants to “print money”, it achieves this by lowering the federal funds rate. Banks are obligated to hold federal funds in reserve overnight, but if necessary, they can borrow these funds from other banks to meet the requirement. The interest rate charged for such borrowing is known as the “fed funds rate”. By reducing the target for the federal funds rate, the FOMC enables banks to borrow federal funds at a reduced cost. As a result, banks have more money available for lending since they are paying less interest.
It is worth noting that the Fed typically imposes a 10% reserve requirement on banks’ deposits. However, in response to the recession caused by the COVID-19 pandemic, the reserve requirement was lowered to zero in March 2020. As soon as the FOMC lowers the target for the fed funds rate, banks make an effort to lend out every dollar they are not obligated to hold in reserve. Consequently, they lower their other interest rates. This increased affordability of capital encourages businesses and investors to borrow, provided that the anticipated returns exceed the prevailing interest rate. This infusion of liquidity stimulates economic growth, similar to the effect of adding money to the overall money supply.
Other Tools Employed by the Fed
The Federal Reserve also employs a strategy called open market operations. This unique approach involves purchasing various securities, including US Treasuries, from member banks and replacing them with credit. It’s almost as if central banks possess the extraordinary ability to conjure credit out of thin air, akin to the concept of printing money.
During the tumultuous period of the COVID-19 pandemic in 2020, the Federal Reserve implemented a notable expansion of open market operations known as quantitative easing (QE). On March 15, 2020, the Federal Reserve unveiled its intention to acquire $500 billion worth of US Treasuries and $200 billion in mortgage-backed securities over the ensuing months.
Shortly after, on March 23, FOMC decided to expand the QE purchases without imposing any predetermined limits. As a result, the Fed’s balance sheet surged to a staggering $7 trillion by May 18.
Moreso, within its arsenal of monetary abilities, the Federal Reserve wields a singular power that transcends the mere creation and annihilation of currency – the remarkable capacity to metamorphose the US debt into an asset of monetizable nature. When the US government orchestrates its Treasury auctions, where the nation’s debt finds eager buyers, the Federal Reserve emerges as one of these formidable purchasers. However, rather than engaging in the conventional practice of trading the acquired Treasuries, the Fed chooses to retain them snugly on its balance sheet. Although the Treasury is bound by an obligation to repay the Fed at a later juncture, the Federal Reserve extends a benevolent hand to the federal government, providing additional funds to be utilized in the interim period.
The method employed by the Fed involves withdrawing these Treasuries from circulation. As a result, the reduced supply of Treasuries increases the value of the remaining bonds. This augmented value enables the Treasury to offer lower interest rates to attract buyers. Consequently, the diminished yield drives down the interest rates on the US debt. With lower interest rates in place, the government can allocate fewer resources towards repaying its loans. This surplus can then be directed towards funding other crucial programs and initiatives.
The Bureau of Engraving and Printing (BEP) is entrusted with the critical task of designing and producing US currency and securities. Through a combination of innovative security features, distinct designs, specialized materials, and meticulous craftsmanship, the BEP crafts a currency that not only deters counterfeiters but also embodies the dignity, strength, and unmistakable identity of the United States.
Hence, every aspect of the currency’s production is carefully orchestrated to create a unique and unmistakably American monetary instrument. The BEP employs distinctive designs, employing intricate patterns, detailed illustrations, and iconic symbols that embody the spirit of the US. These visual elements not only enhance the aesthetic appeal but also play a crucial role in facilitating immediate recognition and differentiation between genuine currency and counterfeits.
To further fortify the security measures, the BEP utilizes specialized paper and ink, meticulously selected for their anti-counterfeiting properties. In a groundbreaking move towards enhanced security, subtle background colours were introduced to the currency in 2003. These discreet hues serve as an additional layer of protection, making it more challenging for counterfeiters to replicate the genuine notes accurately. Furthermore, advanced techniques such as security threads and watermarks are intricately woven into the paper used for denominations starting from $5 and above, making these bills even more impervious to forgery attempts.
The front of the currency incorporates a remarkable colour-shifting ink, which adds an extra dimension of security. This ink possesses a unique characteristic that alters its appearance when viewed from different angles, confounding counterfeiters and reinforcing the authenticity of the notes. In a notable example of innovation, the $100 bill features a captivating 3D security ribbon, an ingenious addition that further deters counterfeiters and captivates the beholder with its optical effects.
Once the arduous process of designing, manufacturing, and incorporating these intricate security features is complete, the BEP undertakes a final inspection to ensure the highest standards of quality and authenticity. The meticulously crafted currency is then sent to the Federal Reserve, the nation’s central bank. As the custodian of the money supply, the Federal Reserve assumes the responsibility of distributing this carefully protected currency across the nation, fostering economic stability and reinforcing trust in the US monetary system.
The process of how the Federal Reserve creates money is more complex than simply printing paper currency. While physical currency is part of the money supply, the creation of money primarily involves a concept known as “monetary base expansion” or “money creation through open market operations”.
Notably, the Fed has the authority to control the money supply in order to manage the economy and stabilize inflation. One of the tools it uses to influence the money supply is open market operations, which involves buying and selling government securities, such as Treasury bonds, in the open market.
It’s also important to note that the creation of money by the Fed is not unlimited or arbitrary. The Federal Reserve operates within a framework of laws, regulations, and policies aimed at maintaining price stability, maximizing employment, and promoting economic growth.