Does the Federal Reserve Create Money?
Synopsis
When someone asks, "How Does the Federal Reserve Create Money?" they base that question on the false premise that the Fed actually does create money. Consistent with the subjective theory of value, only individuals in the market can determine what to use as money. Those individuals have chosen to use various dollar-denominated instruments, but that does not include dollars created by the Federal Reserve because they do not have access to those dollars.
Introduction
I recently read an article by the Foundation for Economic Education entitled "How Does the Federal Reserve Create Money?" In order to respond to this article, I must address the question of does the Federal Reserve create money.
In one word: No.
When I thought about responding to this article, it occurred to me that it was based entirely on a false premise: The Fed does create money. Instead of addressing the pros and cons of the article point by point, I want to address the premise that provides the basis for this question. Using a false premise to support an argument or discussion can only lead to a flawed conclusion.
Define Money
As I have done in most of the articles I have written about money, I want to start with a precise definition. When people write about money, they seem to assume that people have a general agreement as to the meaning of "money." I offer the following definition of money:
Money consists of any economic good, or any claim on such a good, that serves as a general medium of indirect exchange and that acts as a final means of payment.
Book Metaphor
Even this precise definition of money does not address a deeper meaning. What do economic goods and claims on economic goods have in common? To clarify this question, I would like to use the metaphor of what we refer to as "a book."
Nowadays "books" exist in many different forms: printed books (in either hardback or paperback), digital books, audiobooks, and there may exist forms of which I am unfamiliar. But what exactly do these various forms of books have in common that they deliver to the reader? They deliver to the reader a form of information. Information consists of some form of nonrandomness. In the case of the contents of any of these forms of books, the nonrandomness consists of what we refer to as language.
The reader has total control over the meaning contained in that language. The writer has some objective in mind when he composes the words contained in the book. He has no control, however, over whether the reader has the same interpretation. To use phrases like "the words speak for themselves" has no meaning. The reader must read the words and create their own interpretation.
Information in Books
The same holds true of money. In its purest form, money simply consists of nonrandomness delivered to the receiver in one of the media I described above. I have tried to come up with the best word or phrase to describe the essence of money. For the time being, I will use the word "trust." The people who exchange their goods for money trust that the person giving the money received it in exchange for another good or service.
The trust embodied in money attains its value as any other good or service from the preferences of individuals, consistent with the subjective value theory. Only people in the market can determine what they use to represent the trust embodied in money. In other words, only the market can determine what it wants to use as a medium of indirect exchange.
The market, as an interactive group of individuals, has decided that it will accept and use dollars in various forms as media of indirect exchange.
Dollar Creation
In our monetary system, only two entities have the authorization to create dollars: banks and the Fed.
Banks
Only banks have the authorization to create dollars that fit the definition of money. The dollars created by banks can serve as a general medium of indirect exchange. Banks can transfer these money dollars to any legal entity.
The Fed
The Fed also has the authority to create dollars, but the dollars created by the Fed cannot serve as a general medium of indirect exchange. Banks can only transfer dollars held in their reserve accounts to other members of the Federal Reserve. These dollars do not meet the "general medium" criteria, and therefore, they do not qualify as "money."
Excess Reserves
Excess reserves consisted of the total reserves minus the required reserves.
For many years the Federal Reserve used excess reserves as a way to influence the moneymaking capacity of banks.
Before 2008
Before the financial crisis of 2008, banks that had excess reserves could create new money based on the reserve ratio in force at the time. The Fed could influence the amount of excess reserves by making asset purchases and sales in the open market. When the Fed purchased assets the amount of excess reserves would increase. When the Fed sold assets the amount of excess reserves would decrease.
If you look at a chart of the excess reserves in the many years before 2008, you will see that the excess reserves were only a small portion of the total reserves. The small amount of excess reserves gave the Federal Reserve a significant influence on the moneymaking capacity of banks.
After 2008
In the period after 2008, in response to the financial crisis, the Federal Reserve increased the amount of total reserves by a huge amount. The increase in total reserves created an amount of excess reserves in absolute and relative terms greater than at any time since the beginning of the Federal Reserve system. By taking this action, the Federal Reserve basically gave up its influence over the capability of banks to create money. Since that time, only the capital requirements of banks have prevented banks from expanding the money supply with abandon.
Finally, in 2020, the Fed acknowledged its lack of influence over banks' creation of money and eliminated the reserve requirement.
Fed Funds Rate (or IORB): A Closed Market
The writer of the article to which I referred above, and other commentators, have made much ado about federal funds rates. Before I close, I need to make three points about the Fed funds interest rate and the Interest on Reserve Balances (or IORB).
First, no entity, including the Fed, can unilaterally change interest rates. The exchange of current dollars for future dollars determines interest rates. To determine the interest rate (a dependent variable), one must know the amounts of both the current dollars and the future dollars.
Second, the Fed has had only an indirect influence on the Fed funds rate. The Fed could not and cannot trade in the Fed funds market, and prior to 2008 they could only influence the rates in the Fed funds market through their influence on excess reserves.
Third, because the dollars held in reserve accounts do not get used as money, the rate paid on IORB will have little or no influence on the rates paid by customers on notes they sell to banks. The interest paid on IORB will have a very small influence on the amount of money that banks can create because this interest is recorded as income and makes a slight improvement to the capital ratio of the banks.
Conclusion
The question "How does the Federal Reserve create money?" starts with the false premise that the Federal Reserve actually creates money. The interaction of individuals determines what gets used as money, not the government, not the Federal Reserve, nor banks. The individuals in the market have chosen to use dollar-denominated instruments issued by banks as money. Those same individuals cannot use dollar-denominated instruments created by the Fed because they do not have access to them. Reserve dollars do not qualify as a general medium of indirect exchange.
The fact that market actors choose what to use as money also invalidates the premise used by the advocates of MMT that the government issues money. The government neither issues the dollars used as money nor does the government decide what individuals in the marketplace will accept as money.