When we say that the Federal Reserve is printing money, it doesn’t mean that they literally print bills or make coins—that’s the job of the Treasury Department. Today, most of the money in use isn’t cash; it’s credit added to banks’ deposits—quite similar to what happens when your paycheck is deposited into your account. So, when the Reserve is “printing money,” it’s adding credit to the deposits of its member banks.
When the Reserve adds to the money supply that is available for spending and investing, It participates in an “expansive monetary policy.” The money supply available for spending and investing is called liquidity, and it is managed through monetary policy. We also call this “printing money,” and it means that the Reserve encourages investing, borrowing, and economic growth—three factors that help end recessions.
How Does the Reserve Print Money?
When engaging in monetary policy, the Federal Reserve has two tools available.
Federal Funds Rate
First is the federal funds rate, which is managed by the Federal Open Market Committee, the Reserve’s operational arm. Federal funds are the amount of money, banks must hold in reserve each night, and banks can borrow from each other to meet the required amount. The interest rate at which they borrow is the federal funds rate.
To “print money” or to add to the liquidity available, the Committee decreases the target of the federal funds rate so that banks pay less to borrow federal funds. This, in turn, means they have more money to lend, and, ideally, banks want to lend every dollar they aren’t required to hold in reserve, so they will make sure to send that money to qualified borrowers in the market.
Once the rate is lowered, banks lower all other interest rates, which makes capital more affordable. As a result, investors and businesses borrow more money. For example, investments look attractive when their return on investment is likely to exceed the interest rate. In other words, increased liquidity boosts economic growth.
Open Market Operations
Second are open market operations. When the Reserve buys treasuries and securities from banks, it replaces them with credit, thus “printing money.” This is a unique ability all central banks have: they can create money out of thin air.
Between Dec. 2008 and Oct. 2014, the Reserve launched a huge expansion of its open market operations, called quantitative easing, by adding US$4 trillion to the money supply. It bought treasuries, which it paid for by adding credit to the banks. This had the same impact on the US economy as printing 40 billion $100 bills!
How the Reserve “Deletes” Money
Expansive monetary policy can lead to inflation because cheap capital leads to increased asset prices.
We have talked about the Consumer Price Index (“CPI”) and the rise in inflation in 2018. The CPI is the most common measure of inflation, but it doesn’t record all price increases. While it reflects oil prices, it doesn’t include gold and stock prices. And while it measures housing prices, it bases them on rental prices, not selling prices. As a result, the Reserve’s actions can easily create asset bubbles and inflation.
To remedy this, the Reserve can “delete”—or “unprint”—money through contractionary monetary policy that reduces liquidity and effectively removes money from circulation.
The most effective tool, here, is to increase the federal funds rate, so banks have less money to lend and have to pay each other more to borrow money to meet the reserve requirements. As a result of this action, banks will increase all interest rates, increasing the cost of borrowing money for investments, cars, and homes. This slows economic growth and counters inflation.
The Federal reserve can also reverse the quantitative easing by selling back treasuries and securities to banks. And the banks have no choice here—the Reserve just removes dollars from their balance sheets, replacing them with securities. So, while the Reserve can create money out of thin air, it can also make it vanish into thin air.
If you think these abilities by the Federal Reserve, a ‘for profit’ private organization owned by banks, which makes a statutory 6% dividend on its member’s capital investments, goes against all free-market theories that drive the economy, we think you are absolutely right.