Sunday, September 23, 2007

Econbrowser: Money creation and the Federal Reserve

A good description from Econbrowser about the recent Federal Reserve activities.

Econbrowser: Money creation and the Federal Reserve: "Money creation and the Federal Reserve

There seem to be some misconceptions about the monetary consequences of actions that the Federal Reserve has taken to address liquidity needs.

One hears a fair bit of chatter these days along the lines of

The Federal Reserve (and other banking institutions around the world) have poured a couple hundred billion dollars into the system in an attempt to ensure that there is enough 'liquidity' for banks to make loans

and references to

the Fed printing money and increasing the money supply on a high scale as if it was dropping money from an helicopter, thus the nickname of Fed Chairman Ben 'Helicopter' Bernanke.

I hope in this post to get beyond these sound bites, beginning if I may with some details of the process whereby money is created in the United States. Where did the cash in your wallet come from? Presumably you got it from your bank or ATM. And the reason that the bank was willing to give you that cash was that you already had deposits in an account with the bank, which were in effect credits to obtain cash when you wanted it.

And where did your bank get that cash? If it is a member of the Federal Reserve, your bank got it from a Federal Reserve Bank. And the reason that the Federal Reserve was willing to give your bank the cash was that your bank had deposits in an account with the Fed, that give it credits to obtain cash when it wants it. These credits are known as Federal Reserve deposits, which I'll simply refer to here as 'reserves' for short.

And where did those reserves come from? The standard mechanism is that the Fed purchased Treasury bills from independent securities dealers, paying for them by creating new reserves in the dealers' banks. The Fed now is the owner of the Treasury bills, and those banks now have new reserves, which they could use to obtain new dollar bills, if they desired.

To follow what's happened over the last 6 weeks, it's necessary to add a few details to this basic story. For day-to-day fine-tuning of interest rates and the money supply, the Fed usually does not use outright purchases of Treasury securities, but is more likely instead to rely on repurchase agreements, or repos. A repo is a short-term loan, often overnight or for just a few days, made by the Fed through a private securities dealer, which the Fed again provides by creating new reserves at the dealer's bank. As collateral for the loan, the Fed temporarily takes possession of high-quality securities. A few days later, the securities are returned to the original owner and the reserves come back to the Fed. Although its effects are strictly temporary, on any given day the Fed's outstanding repos have created reserves and thus potential dollars in circulation."

Continue reading the article here


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