Most of us think that it is the Federal Reserve Bank (Fed) which creates money in the US, but it is not.
Let’s start with the word “created”. In order to have price stability the money in circulation needs to approximate what we produce – both goods and services – and therefore as our productive capacity increases, our money supply must also. How does that happen?
Essentially all our money is created in the private banking system by your bank around the corner. Every time you take out a loan, the amount that is deposited in your account is newly created money – out of thin air so to speak. The converse is also true, being that the principal you pay back on a loan is automatically destroyed in the bank’s books.
But you ask what about all the money the Fed has been printing, called Quantitative Easing (QE)? Here is how that works. As you might know, the Fed can create money for its own balance sheet (private banks can only do that for customers). The Fed buys either Treasuries or mortgage securities guaranteed by the federal government, but only on the secondary market and not in the primary market. This means that someone must have owned them first and created a price for them. With the funds created under QE the Fed only purchases from banks (under normal conditions). The way it purchases these securities is by depositing the purchase price in the reserve accounts of selling banks held at the Fed. This means that QE only increases reserves and does not increase the money supply on Main Street. What is the desired effect? Per Janet Yellen: “Portfolio rebalancing”, meaning that as the Fed purchases assets, the interest rates on these decrease. In order to increase their profits, the previous owners then move into riskier assets and increase their values, supposedly increasing production. Banks do not lend out their reserves, but under prior conditions (i.e., prior to QE) these were meant to act as brakes on lending due to the mandated ratios between bank assets (i.e., loans) and their reserves. This is not the case now. So, no money on the street is created through QE.
Okay, what about paper bills? These are printed by the Treasury and then transferred to the Fed. The Fed pays Treasury for the cost of printing these, a negligible amount versus their face value (about 10 cents for a $10 bill). So this is a straight purchase by the Fed from Treasury. The Fed then transfers these to individual banks as desired by them and paid for with the reserves on deposit by that bank. Bank reserves equal deposits at the Fed plus cash in vault, meaning that so far nothing has changed on Main Street. But, the purpose of banks having cash in their vaults is to get it to the customers who desire it. That cash is “sold” to customers in return for their deposits, 100% of which were created through loans. So again, even for cash, it all is created by “deposit creation” through debt from customers at private banks.
Only coins are now left for our analysis. Treasury stamps these and moves them directly at face value into its account at the Fed. The question then becomes what is the cost of stamping these in aggregate. Compared to their face value, some are more expensive to stamp (e.g., pennies) and some cheaper. In total, it is a reasonable assumption that the cost of production is about equal to the face value. As with bills, these are then moved to individual banks and then customers as desired, with the same analysis as for bills.
In conclusion therefore, as close as can be approximated, 100% of our money is created through debt at private banks and not by the Federal Reserve Bank.