MATTOLE SELF-SUFFICIENCY PROJECT

How the Federal Reserve Bank Creates Money

The first step is when the US Congress instructs the US Treasury department to issue interest-bearing bonds. These bonds may be sold directly to the Federal Reserve Bank (usually the FRB of New York) or sold on the open market. When the FRB buys a US Treasury bond, it simply credits the US Treasury account with the amount of the bond. The Treasury bond is now considered an asset of the FRB.

Suppose that the US Treasury bond is for $1 billion. Where did the FRB obtain the $1 billion to buy the treasury bond? The answer is that the FRB created the $1 billion out of thin air as a book-keeping entry in a computer database. Bear in mind that the US government, i.e., the tax-payers, is paying interest on this $1 billion that was created out of nothing.

As the US Treasury writes checks on its account, money is transferred from the US Treasury account to the accounts of various businesses and individuals that are paid by the US government. Hence, most of that $1 billion winds up in the reserve accounts of various commercial banks that are held by the 12 Federal Reserve regional banks. Some of this money is made available as currency when the Federal Reserve Bank asks the US Treasury Department to print more Federal Reserve notes.

The Federal Reserve Bank controls the money supply by buying and selling government bonds on the open market in what are called "Open Market Operations." When the Fed wishes to decrease the money supply, it sells government bonds and simply cancels out that amount of money from the account of the person or corporation buying the bonds. This decreases the amount of reserves available for commercial banks to make loans and thus decreases the money supply (M1).

When the Fed buys government bonds on the open market, it creates the money as it does when it buys those same bonds directly from the US Treasury. This increases the reserves available as described above.

Last Updated: 23 Mar 2005