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Understanding Fed Money Mechanics

Tags Money and Banking


It is vitally important that those of us who criticize central banking and endorse the private provision of commodity money understand how the Fed operates.

To that end, this out of print (1991) publication of the Federal Reserve Bank of Chicago provides an excellent summary of Fed money mechanics.

A few notes of interest: First, some of the numbers contained in this workbook (from December 1991) seem downright quaint today, e.g. the then-total M1 money stock of $898 billion has since quadrupled. Second, the workbook alludes to the now defunct broader M3 monetary base, which the Fed Board of Governors no longer compiles because "the costs of collecting the underlying data and publishing M3 outweigh the benefits." Third, the workbook states that "unused or excess reserves earn no interest," which is no longer the case since 2008, when the Fed starting paying interest on depository institution reserve balances.

The program of Interest payments on excess reserves (IOER) was authorized statutorily by the Financial Services Regulatory Relief Act of 2006 (with the effective date for beginning such payments changed from 2011 to 2008 by the Emergency Economic Stabilization Act of 2008). These interest payments (currently .25%) create a de facto floor for interbank lending, i.e. the Fed Funds rate. Yet even a zero Fed Funds rate—and ZIRP is the unspoken Fed policy—doesn't change the fact that banks cannot lend reserves to commercial nonbank customers. Banks are capital constrained, not reserved constrained. And they are cautious in an era of virtually no real economic growth and limited creditworthiness among borrowers. This is why all of the Fed's enormous expansion of the monetary base since 2008 has done little to spur lending in the general economy. Finally, the links to illustrations appear to be broken, but this html file still reads better than some of the PDF versions floating around.  

From the introduction:

The purpose of this booklet is to describe the basic process of money creation in a "fractional reserve" banking system. The approach taken illustrates the changes in bank balance sheets that occur when deposits in banks change as a result of monetary action by the Federal Reserve System - the central bank of the United States. The relationships shown are based on simplifying assumptions. For the sake of simplicity, the relationships are shown as if they were mechanical, but they are not, as is described later in the booklet. Thus, they should not be interpreted to imply a close and predictable relationship between a specific central bank transaction and the quantity of money. The introductory pages contain a brief general description of the characteristics of money and how the U.S. money system works. The illustrations in the following two sections describe two processes: first, how bank deposits expand or contract in response to changes in the amount of reserves supplied by the central bank; and second, how those reserves are affected by both Federal Reserve actions and other factors. A final section deals with some of the elements that modify, at least in the short run, the simple mechanical relationship between bank reserves and deposit money.


Contact Jeff Deist

Jeff Deist is president of the Mises Institute. He previously worked as chief of staff to Congressman Ron Paul, and as an attorney for private equity clients. Contact: email; Twitter.

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