Read this chapter by John Petroff. Focus particularly on the section, "Open Market Operations."
Money Creation—Monetary Policy
In this chapter, we investigate various monetary policy tools, how banks create money, open market operations and how the U.S. Federal Reserve controls money creation.
Banks receive and lend the deposits they receive from individuals and businesses. They derive their revenue from the interest they charge borrowers on loans and fees for other services. Loans, rather than check deposits, withdrawals, and payments, change the money supply. Banks in the United States are required to hold a portion of deposits in reserves.
|Banks are private businesses just like car manufacturers or retail stores. The primary service they provide is to make loans from the deposits they receive from individuals and businesses. They charge borrowers an interest rate that is higher than the amount of interest they pay to those who deposit money in their bank. This difference provides them with a profit that keeps them in business.|
When an individual writes a check and a payment is made, the total, overall money supply does not change. Only the composition, or distribution of money changes into a different form. A check payment merely shifts reserves from one bank to another, when the check clears through the U.S. Federal Reserve.
|If I withdraw $100 from my checking account, $100 more bank notes are in circulation, but I have also reduced my check writing ability by $100. Consequently, the total money supply does not change. This same logic applies when a check payment and deposit is made from one individual to another.|
Money is created when banks make a loan: the bank accepts a promissory note from the borrower (which is not money) and gives the borrower the ability to make payments in the form of demand deposits, up to the amount of the loan. When the borrower repays the loan, money is canceled. In normal circumstances, the volume of new loans exceeds the repayment of loans. Consequently, the money supply keeps increasing. However, a bank can only loan up to its available excess reserves.
|Let's say I take out a car loan for $10,000, and pay the car dealer $10,000 (including the down payment) for the new car I just bought. The transaction creates an additional $10,000 which is now in circulation. The bank accepts my promise to repay in exchange for the loan. While, my promise to repay is not money, the $10,000 is.|
The money supply decreases when the borrower repays a loan—they must use demand deposits to make the repayment. This takes some cash or demand deposits out of circulation.
|A misconception stems from the everyday expression, "making money" to describe making a profit. When banks earn profits by charging an interest on their loans, this profit has nothing to do with money creation. Quite the contrary: a careful analysis would show that the interest the bank charges has to be paid with money in circulation. Consequently, the interest payment on loans cancels, rather than creates, money.|
Reserves describe the funds a bank holds in its vaults or in its account at the U.S. Federal Reserve. Banks are required to keep a proportion of their deposits in reserves. They are only allowed to lend out their excess reserves. Required reserves refers to the portion of reserves a bank must keep on hand. Reserves are never part of money supply. They are called "high powered money" because they can create a multiple of money supply.
|When they were first formed, U.S. banks were required to hold required reserves, to ensure they have a sufficient funds on hand for depositors to make withdrawals. Today, banks are still required to maintain certain reserves, but this requirement is so the U.S. Federal Reserve is able to conduct monetary policy.|
Required Reserve Ratio
The required reserve ratio refers to the proportion of required reserves compared to deposits. There are several different ratios according to the degree of permanency of the deposits. The ratios vary from less than two percent to more than 15 percent. The U.S. Federal Reserve sometimes change these ratios according to economic needs.
|The required reserve ratio for different types of deposits depends on the likelihood that the funds will be withdrawn. For example, the required reserve ratio is about 12 percent for checking account deposits and about three percent for business certificates of deposit (with a two-year maturity date or more).|
The excess reserves of one bank are transferred to a second bank, when a borrower uses their loan proceeds to make a payment. The bank must keep a portion of these funds as required reserves, but it can lend out any excess reserves. Successive re-lending of excess reserves accumulates as total money creation, which is often several times the initial loan. This monetary multiplier equals the inverse of the required reserve ratio.
|The monetary multiplier describes the multiplier effect that occurs when several banks lend each dollar of excess reserves several times. If banks were not required to maintain a certain level of required reserves, the re-lending could go on ad infinitum: money creation would be tremendous. This situation could occur for Eurodollar account balances where reserves are not officially required. However, prudence in Eurodollar banking has kept the monetary multiplier low.|
Banks prefer to invest in government securities because they are considered a safe investment compared to loans to private businesses, and they are relatively liquid. Banks often hold their excess reserves in government securities. When a bank buys a government security from an individual, the transaction is equivalent to a loan and increases money supply. The U.S. Federal Reserve holds a large stock of government securities and is responsible for their issuance and redemption.
|Many U.S. and foreign investors prefer to invest in U.S. Treasury Bills (TBs) because they offer a safe investment that is liquid, or easy to convert into cash. Owners can choose to redeem or rollover certain TBs every 90 days. Banks like to purchase these safe and liquid loans from the government.|
Monetary Policy Tools
The U.S. Federal Reserve has certain tools of monetary policy that control the excess reserves of banks. These include open market operations, changes in required reserve ratios, and changes in the discount rate. Changes in required reserve ratios affect reserves directly, but are considered too authoritarian for frequent use. Changes in the discount rate make it easier, or more difficult, for banks to borrow from the Federal Reserve, but the volume of bank borrowing is small.
|The belief that the U.S. Federal Reserve's control over the physical printing of bank notes is the essence of monetary policy is not entirely correct. The monetary multiplier shows that banks have the ability to create most of our money supply. Control over the amount of excess reserves banks can lend, is the real focus of monetary policy.|
Open Market Operations
Open market operations describe the U.S. Federal Reserve's purchase and sale of government securities. This activity offers the most common and potent tool of monetary policy because it is flexible, subtle, and effective.
|The U.S. Congress established the Federal Open Market Committee when it passed The Bank Act of 1935. This committee is composed of the seven members of the Federal Reserve board of governors, plus several regional Federal Reserve Bank presidents. This committee is responsible for setting the monetary policy of the Federal Reserve. This underscores the importance of open market operations as a tool of monetary policy.|
The discount rate is the interest rate the U.S. Federal Reserve charges its member banks to borrow money. The amount of these loans is relatively small. When a change in the discount rate occurs, it usually reflects changing economic conditions rather than an intended monetary policy action. However, these Federal Reserve decisions to act offer investors a strong message about the direction of monetary policy.
|In Fall 1988, the U.S. Federal Reserve raised the discount rate from six to 6.5 percent. This change followed a period of rising interest rates with a moderate increase in inflation. We are not sure whether the Federal Reserve increased the discount rate as a policy action or to adjust the prevailing market rates. In 2001, the Federal Reserve lowered the discount rate a record seven consecutive times to force lower interest rates and renewed loans. The press widely publicized the Federal Reserve's action to lower the discount rate.|
Tight Money Policy
The U.S. Federal Reserve adopts a tight money policy by reducing excess bank reserves, which restricts a bank's ability to create money. The Federal Reserve encourages banks to buy government securities in the open free market. Banks are eager to put their excess reserves in government securities, because they are safe investments. The Federal Reserve also implements a tight money policy by increasing the required reserve ratios, or the Federal Reserve discount rate.
|In 1979, Paul Volker was appointed chairman of the Federal Reserve during a period of rapid monetary growth. In 1981, the Federal Reserve implemented various tight money policy tools to bring credit expansion growth under control.|
Easy Money Policy
The U.S. Federal Reserve adopts an easy money policy to increase the excess reserves banks have, to make it easier for banks to create money. The Federal Reserve buys government securities from banks, which are usually the largest owner. The Federal Reserve can also implement an easy money policy by lowering the required reserve ratios, or the Federal Reserve discount rate.
|In 1982, Paul Volker, chairman of the Federal Reserve from 1979 to 1987, switched to an easier monetary policy that allowed slightly faster money growth to avoid reducing investment and economic growth. In 2001, Alan Greenspan, chairman of the Federal Reserve from 1987 to 2006, applied a forceful easy money policy to try to avoid the oncoming recession.|
Minor Monetary Policy Tools
In addition to open market operations, changes in required reserves ratios and the discount rate, the U.S. Federal Reserve may also affect the money supply by changing margin requirements—the proportion of funds a securities dealer must have in its account to conduct transactions. This is similar to consumer credit terms, such as a required downpayment or time restriction to repay a car loan. Another, less common, method is to persuade banks to adopt desirable conduct through "moral suasion."
|Many governments carry out monetary policy via direct contact between the central bank and the banking community (Americans call this contact, moral suasion). For example, Canada's central bank, the Bank of Canada, is able to maintain these relationships because it only has seven major banking institutions. This contact is not possible in the United States, due to the large number of private banks.|