How Does the Federal Reserve Create Money?

"The U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes." So spoke Federal Reserve Governor Benjamin Bernanke in 2002, prior to becoming the central bank's presiding chairman during the credit crisis and stock market crash of 2008. A scholar of the Great Depression, when the country was wracked with a painful deflation of asset values, Bernanke was keenly aware the government's ability to create money out of nothing by running the proverbial printing press, though controversial, had become a driving force of the twenty-first century U.S. economy.

The Creation of Money

To understand the process of how the printing press works to create money out of thin air, the nature of money itself must be understood. The real money of the United States is not the Federal Reserve Notes that circulate in the economy, but the Treasury bills and bonds secured by the "full faith and credit" of the U.S. government. Only the holder of a U.S. Treasury has the promise of payment from the government out of future taxes collected from U.S. citizens, and this promise to pay is essentially the only value behind what passes as "money."

The market for U.S. Treasuries is one of the largest and most liquid in the world. To create new dollars, the Federal Reserve monetizes the government's debt. That is, it simply buys Treasuries on the open market and credits the seller's account for the transaction. This is the "electronic equivalent" Bernanke mentioned in 2002. The value added to the seller's account does not actually exist except on the digital balance of the bank's reserves.

With the Fed's purchase of Treasuries, money has in effect been created out of nothing, but the process doesn't necessarily end there. The Fed buys in volumes that can only be met by large financial institutions, who, once the value has been added to their reserves, can then invest or lent these funds, which in itself is part of the creation of new money. All modern banks work on a system of fractional reserve lending where more can be lent than is actually held in reserve. There are some restrictions, however. In general, banks can lend $10 for every $1 on reserve, and in doing so, they represent the final step in the process of the creating new money.

Credit Crisis

The Fed's printing press underwent interesting changes to confront the 2008 credit crunch. Whereas the Fed had previously only accepted government debt, such as Treasuries, it initiated new lending facilities where banks could exchange less secure collateral, such as mortgage backed securities, for cash. When the crisis worsened, the Federal Reserve acted in conjunction with banks around the world to guarantee all interbank lending, potentially monetizing all of the banking system's "toxic" obligations.