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Understanding Money

How the Fed Creates and Destroys Money
Part I

Every day, in order to fine tune the United States' money supply, the Federal Reserve creates or destroys several billion dollars.

As we discussed earlier in the essay, the Fed does this in order to maintain the money supply at the level they think is best for the economy. What I am sure you are wondering is, how do they do it? How does someone create several billion dollars? For that matter, how does someone destroy a billion dollars?

Banks have a variety of different holdings. Aside from cash, they also hold bonds and other financial instruments. It is the bonds that are important here, so let's talk about them for a minute.

A BOND is a debt issued by a company, government or government agency in order to borrow money for a specific amount of time. To obtain the money, borrowers make two promises. First, they promise to make regular interest payments. Second, they promise to pay back the original sum of money after the specified amount of time has passed. In other words, a bond is a type of IOU.

Here is a typical example to show you how it works. Let's say the XYZ Company wants to borrow $1,000,000 for 10 years, and they are willing to pay 5% interest a year, with payments every 6 months. (Most bonds pay interest every 6 months.) It will be difficult for them to find one person or one company willing to loan them the entire $1,000,000, so, instead, they will sell 40 bonds for $25,000 apiece.

Let's take a moment to figure out the interest. The XYZ Company has promised to pay 5% a year. For a $25,000 bond, this means $1,250 a year ($1,250 = 5% of $25,000). Since the payments must be made every 6 months, the XYZ Company will need to make regular payments of $625 (half of $1,250).

You decide to buy one of these bonds, so you give the XYZ Company $25,000. In return, they agree to pay you $625 in interest every 6 months for 10 years. At the end of the 10 years, the XYZ Company will pay you back the $25,000. From the company's point of view, the bond is a way for them to borrow money at a fixed cost for a specific amount of time. From your point of view, the bond is an investment that provides you with predictable income for 10 years.

Who buys bonds? People, companies and governments that want a guaranteed rate of return on their investments. For example, many retired people buy bonds and live off the interest. Many governments buy bonds in order to earn income from their surplus funds.

Who sells bonds? Any organization that wants to borrow money for a specific amount of time. For example, a city might issue bonds in order to pay for a new high school.

No doubt, you have heard that the U.S. government borrows a huge amount of money. They do so by having the U.S. Treasury issue various types of bonds. To borrow money for a short amount of time (defined as 1 year or less), the Treasury issues what are called TREASURY BILLS. To borrow money for a medium length of time (between 1 and 10 years), they issue TREASURY NOTES. To borrow money for a long period of time (over 10 years), they issue TREASURY BONDS. For our purposes, we can consider them more or less the same, so I'll refer to all of them as Treasury bonds.

In case you are wondering how much money the U.S. Government owes, as of the day I am writing this (June 21, 2009) the federal debt is more than $11 trillion, to be precise, $11,410,784,275,720.64. (What I want to know is, what's the 64 cents for?)

You might be wondering, how fast does the this debt grow? At the time I wrote the first version of this essay (May 24, 2001), the federal debt was a bit over $5.6 trillion: $5,660,965,921,275.71. This reprsents an increase of 49.6 percent in 8 years.

So what does this have to do with banks and the Fed? In the previous section, I explained how new money is created when banks loan out money that has been deposited with them. The loaned money is deposited in another bank, where it is loaned out again, creating even more new money. The money that a bank has in cash can be loaned out, but the money it has in bonds just stays where it is. Since bond money does not get loaned out, it does not circulate and create more and more money.

Thus, it is possible for the Fed to control the size of the money supply by controlling how much money the banks keep in cash (which is loanable) compared to how much money they keep in bonds (which is not loanable). To increase the money supply, the Fed moves some of the banks' money from bonds into cash. To decrease the money supply, the Fed moves some of the banks' money from cash to bonds. The details are complex, so we won't deal with them here. Basically, each day, the Fed buys (or sells) several billion dollars worth of U.S. Treasury bonds from (or to) certain financial companies who act as dealers.

Let's say that, on a certain day, the Fed buys $4 billion dollars worth of Treasury bonds from a particular dealer. To do so, the Fed takes possession of the bonds (electronically) and puts $4 billion in the dealer's bank account. The dealer's bank now has $4 billion more to loan out, which, in the way I have described above, creates a lot of new money. Thus, by buying bonds, the Fed has increased the money supply of the country.

Now, let's say that, a month later, the Fed wants to decrease the money supply, so they sell $4 billion worth of bonds to a particular dealer. To do so, they credit the dealer with possession of the bonds and take $4 billion out of the dealer's bank account. The dealer's bank now has $4 billion less to loan out, which decreases the money supply.

At this point, you are probably wondering, where does the Fed get all the money to buy and sell such large quantities of Treasury bonds? The answer is — and this is the coolest part of all — they don't really have the money; they just make it up.

Do you remember in the previous section, when I observed that, if your bank were to credit your account with a million dollars, you would, all of a sudden, have an extra million dollars to spend? One reason why your bank doesn't do this is that banks can't just go around giving people money out of nothing. If your bank wants to credit your account with money, that money has to come from somewhere.

The Fed is a different type of bank. They are allowed to credit accounts without having to come up with real money. Thus, when the Fed puts a $4 billion credit in the bank account of a bond dealer, the money doesn't have to come from anywhere. The mere fact that the Fed puts it in a bank account is enough to create the money. Similarly, when the Fed takes $4 billion out of a bank account, the money doesn't go anywhere. It just ceases to exist.

Does this mean that, if the Federal Reserve wanted to, it could credit your bank account with a million dollars without causing a bookkeeping problem? Absolutely. The trick, of course, is to get them to want to do so. If you'd like to try, their phone number is (202) 452-3000. Ask for Mrs. Yellen.

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