Judd W. Patton, Ph.D. (Biography) Bellevue University Online
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ABC'S of Federal Reserve Money Creation
Dr. Judd W. Patton

     In 2000 the Federal Reserve - also known as the "the Fed" increased the nation's quantity of money, or money supply known as M2, by about $291 billion dollars. How was this done? Here is a brief explanation.

     Each bank in the United States, about 14,000, is required to hold a fraction of their customer's checkable and time deposits on reserve, either as vault cash or in an account at the Fed. Required Reserves do not earn the banks any interest return whatsoever.  Reserve Requirement percentages vary from 3% to 12% of a bank's total checkable deposits (time deposits are 3%).  Should a bank have more funds on Reserve than what is legally required, it has Excess Reserves.

      In a fractional reserve banking system, banks have an obvious incentive to loan out any Excess Reserves (otherwise they earn nothing on these funds). Therefore, the greater their Excess Reserves, the more potential loans (credit expansion) the banks can make.

      Now we come to a critical point. The Fed has the ability to manipulate and determine Reserve Requirements and Total Reserves in the banking system. They have three tools:  Open-Market Operations, Discount Rate changes, and Reserve Requirement changes.

      By far the most important tool is Open-Market Operations.  By buying or selling U.S. Treasury securities in the open market, the Fed directly affects Bank Reserves.  For example, when the Fed purchases securities, it writes a check on itself - in effect, the check is created out of thin air! The check will then be deposited in a bank.  Let's call it Bank A.  When the Bank forwards the check to be cleared, the Fed credits the Bank's Reserve account. Assuming the Fed purchased a $1,000 dollar security, Bank A obtains $1,000 dollars in new Reserves (an asset) and $1,000 dollars in additional checking deposits (a liability) from its customer. So the money stock has grown by $1,000 dollars at this point.  However, with a 10% Reserve Requirement, Bank A will set aside $100 dollars and proceed to loan out $900 dollars. The money stock has now increased to $1,900 dollars. (The credit expansion manifests itself in new checkable deposits and/or time deposits of the loan recipient.)  But this is hardly the end of the story.

     The customer who borrowed the $900 dollars from Bank A will spend their money.  Suppose she writes a check that ends up being deposited at Bank B. After the check has cleared, Bank B has new Reserves of $900 dollars.  It keeps $90 dollars on Reserve (10%) and loans its Excess Reserves of $810 dollars.  The money stock increases again!  (The total increase so far is $2,710, or $1,000 + $900 + $810 dollars.) This process of lending and holding back a fraction of new deposits continues until the $1,000 dollars is held in Reserve at various banks.  At a 10% average Reserve Requirement, the money stock will grow to $10,000 dollars, a ten-fold increase of the initial Fed purchase!

      In short, the Fed purchase of $1,000 dollars increases total Bank Reserves by $1,000 dollars, and this makes possible a multiple expansion in loans and deposits (new money). The magic of fractional reserve banking is based on the Fed's ability to increase Bank Reserves, either through Open-Market purchases, lowering Reserve Requirement percentages, or encouraging banks to borrow Reserves from the Fed by lowering the discount rate (interest rate) the banks must pay for the loan. 

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