Zaks Investment Advisory Service

How the Federal Reserve increases the amount of money in the banking system

I would like to remind our listeners that last time, we began looking into how our central bank, the Federal Reserve, tries to influence interest rates. Along the way, we tried to determine what money is and what role banks play in creating “new money.” We also learned that one mechanism the central bank uses to regulate amounts of money is through the reserves that banks by law must keep with the Federal Reserve.

Thus, as we have already said, the Federal Reserve influences interest rates by regulating the amount of money in our economy. In the old days, the government used to literally print money. Print several billion dollars worth of notes and the amount of money in the economy goes up. But modern, developed countries no longer resort to such primitive measures. How does the Federal Reserve do it? It has several means at its disposal, but the main one sees the Federal Reserve buying and selling securities – usually, Treasury bonds. Why Treasury bonds? We will not delve into the technical details, but theoretically, the Federal Reserve could buy and sell almost any securities to achieve this.

Because the Federal Reserve is a special buyer, such simple transactions change the amount of money in the economy. Here is how it works. Imagine that the Federal Reserve decides to add money to the banking system. It turns to Treasury bond dealers and, thanks to the fact that their market is huge, buys bonds worth, for example, 10 billion dollars. The dealers hand the bonds over to the Federal Reserve, which in turn pays the dealers – in reality, those dealers’ banks (just like when your salary gets paid by direct deposit to your bank, as is often the case). But of course, the Federal Reserve uses a special way of paying: it does not send cash to the bank. Instead, the central bank adds the corresponding amount to the bank’s reserve account (and does so through an electronic transaction).

Now let us recall what we said a moment ago: the Federal Reserve regulates the amount of money a bank may lend. How does it do it? The Federal Reserve ties the amount of lending to the amount of money a bank holds in its Federal Reserve account. Imagine what would happen should the Federal Reserve add money to a certain bank’s account. Imagine it was J.P. Morgan Chase. Like any other bank, J.P. Morgan Chase makes money by making loans. The more money it is able to lend, the more it can earn. But as we have said, the Federal Reserve sets certain limits on banks, associated with the amounts of money they must keep in reserve. The more money in the reserve, the more lending a bank may perform. As so, our J.P. Morgan Chase, which had been limited in its lending ability, suddenly finds itself being able to make an additional, say, one billion dollars worth of loans. Which J.P. Morgan Chase will of course do as soon as it can, since this is its line of work. Now let us recall one other thing we talked about: one billion dollars of “new money” create several billion dollars as they go through the banking system. Thus, by buying Treasury bonds worth, say 10 billion dollars, the Federal Reserve is infusing many tens of billions of dollars into the country’s economy.

And so, the central bank purchased the Treasury bills, and J.P. Morgan Chase received extra money in its Federal Reserve account (we have already mentioned that these are called “federal funds”). And, of course, it gained a newfound opportunity to issue loans. J.P. Morgan Chase has a chance to make money, but in practice this will take time: it needs to find a client. In the mean time, it has “extra money,” so to speak, that it would like to somehow make use of, since it earns no interest by simply sitting in the central bank account. On the other hand, imagine that some other bank, say Citibank, was working all day, making payment transactions, opening credit accounts, and discovering at the end of business hours that it was short of federal funds. Citibank knows it has to do something; otherwise, the Federal Reserve will fine it. What can it do? Very simple: it turns to J.P. Morgan Chase and borrows its extra federal funds: obviously, it borrows at a certain rate, which is called the “federal funds rate.” It borrows the money for just one day since it knows that by tomorrow, it will be able to correct its imbalance and be back within limits set by the central bank – or, if worst comes to worst, to borrow money for one more day. And thus, as a result of this transaction, J.P. Morgan Chase earns money while Citibank observes the laws prescribed by the Federal Reserve. These types of transactions are very frequent: the federal funds interbank trade is an enormous market whose daily volume stands at tens of billions of dollars.

What have we learned today? That our central bank, the Federal Reserve, by purchasing and selling securities, creates additional funds in the accounts of regular banks. These additional reserves potentially allow banks to create new loans – and thus to increase the amount of money in the economy. Moreover, we discovered that until they find new clients, banks are able to use these extra funds to make very short-term loans to other banks – obviously, at a certain rate – and to earn additional money. As you may have guessed, this could not but have an effect on short-term interest rates. But more on that later.

And with this, we will have to draw our program to a close. This was Sergey Zaks. Thank you for your attention and until next time.