The Fed does not print money

The Fed creates reserves, not money.  I’ve covered this one before.  Fed Chair Ben Bernanke has been making the same distinction lately, though it seems he’s muddied it in the past.

Once again:  The Fed creates reserves, not money.  The Fed buys securities from banks and pays for them by giving the banks reserves, e.g., if it buys a $1000 Treasury bond from a bank, it pays the bank by adding $1000 to the bank’s reserve account  at the Fed.  This is not the same thing as giving the banks money, because it ain’t money unless it’s (1) cash circulating outside of the banking system or (2) in someone’s checking, savings, or other deposit account at a bank or money-market fund.

This distinction might sound nitpicky, but it’s all-important.  The process by which these reserves become money is the process by which monetary policy works, or fails to work.  What’s supposed to happen is this:

Fed creates reserves –> banks loan out reserves to households and businesses –> households and businesses spend those funds (raising the Consumption and Investment parts of GDP, hence raising GDP) –> whoever gets paid by them deposits some of those funds in the banks or in money-market funds, and spends some of it –> whoever gets that money deposits some of it and spends some of it –> etc.  Money does get created, indirectly, when those loans are deposited or redeposited in the banking system, but not before then.

That’s what happens when monetary policy works.  (And yes, there may be some inflation, if the increased demand for consumption and investment goods isn’t met by an increase in their availability.)  But that’s not what’s been happening since 2008 — the Fed has been creating reserves, and banks have mostly been sitting on those reserves.  Thus no big increase in Consumption, Investment, or GDP, and no corresponding increase in the money supply.

When someone says “The Fed prints money,” what they’re really saying is that they don’t know what they’re talking about.

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2 Responses to “The Fed does not print money”

  1. Mark E. Says:

    Great explanation, especially since you actually explained it such that you didn’t muddy the waters further, to borrow your wording . I think the confusion is often the word “Fed”. I can see where someone would think that to stand for the entire Federal Government, which obviously does print our currency. Then again, that just leads to another confusion over what money is.

    Seriousness aside, in favor of the frustrated rants of just another cog in the machine, I guess what I’m trying to say is that if Bernanke wants more money in circulation, perhaps the Fed could bypass the banks. That would end any need for discussion on the difference between money and reserves. These banks don’t seem to deserve another dime anyway.

  2. Ranjit Says:

    Mark,

    I’ve wondered about that myself: What if the Fed just bypassed the banks? It could buy T-bonds from people instead of banks and credit their bank accounts. That would directly increase the money supply (i.e., bank deposits), though it would be unlikely to spur consumption or business investment, since the rich folks who own most of the T-bonds would probably save rather than spend the sale proceeds.

    Then there’s the classroom exercise made famous by Milton Friedman: a “helicopter drop” of cash, which would instantly increase the money supply and almost all of which would presumably be spent right away (well, depending on where you dropped it). If the economy entered a severe enough deflation, I think you’d want to consider this. On the down side, it would probably get the Fed’s charter revoked or at least give centuries’ worth of fuel to conspiracy theorists. Just make sure it’s a black helicopter.

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