Next Article



The Big Picture

This overview provides a short introduction to the U.S. monetary system.  Details can be found in later articles.  The terms in italics are links to the Glossary and back.

1.  The banking system, including the Federal Reserve, is the source of all dollar-denominated money.  The Fed creates the monetary base, also known as Fed money, comprising notes and coins and deposits at the Fed.  Banks expand the money supply by issuing loans, and thereby create credit money.

2.  The Fed influences the amount of bank lending through its selection and control of the Fed funds rate, the benchmark for all short term interest rates.  However it does not directly control the amount of credit money created by commercial banks which are private profit-seeking enterprises.

3.  The amount of money created is a function of the demand for bank credit at the going lending rate.  Banks normally lend to any borrower who is found capable of paying the interest and returning the principal on a date-certain.  Bank-issued credit money is the principal part of the money supply.

4.  A bank's lending is ultimately limited by the amount of its equity, based on the capital ratio requirement set by the Fed.  Banks must also meet a reserve ratio requirement, but in fact the Fed normally provides the required reserves in order to maintain control of the interbank lending rate, i.e. the Fed funds rate.

5.  The Fed controls the Fed funds rate through its open market operations, buying or selling securities short term for its own portfolio.  This adds or drains banking system reserves as needed to balance supply and demand at its chosen target rate.  Banks temporarily short of reserves may borrow directly from the Fed's discount window.

6.  To support the increasing demand for currency and bank credit money, the Fed purchases Treasury securities directly from the public.  This is referred to as monetizing the debt, which increases the monetary base in direct proportion to the increase in the value of Treasury securities held by the Fed.

7.  Government spending via the Treasury does not increase the money supply.  It spends funds recycled from the public through taxes and/or bond sales.  The government could print money to cover its spending, but that hasn't happened since the Accord of 1951.

8.  The Treasury does not accumulate money balances in excess of its near term obligations.  Thus the reciprocal flow of funds between the Treasury and the public is essentially balanced at all times, whether the budget is balanced or not.

9.  The national debt owed to the public by the Treasury can be maintained indefinitely by simply rolling over T-bonds as they mature.  When the budget is balanced, current tax revenues fully cover interest paid on the debt.

10. Paying down the national debt does not free up money for either the public or the government.  Every dollar of debt paid off merely transfers dollars from taxpayers to bond owners, and dissolves assets used as a savings vehicle by the public.

Next Article       Home