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6 Money Creation Primer
The creation of new money “out of thin air” works like this:
- The government prints up a piece of paper called a treasury bond. This is simply an IOU, a promise to pay the holder a specified sum of money on a particular date. In this example, let’s say the government issues $1,000,000 worth of bonds.
- The Federal Reserve prints up a piece of paper called a check, in the amount of $1,000,000 and makes it payable to the government. There’s nothing of real value backing up this check at all.
- The Fed and the government trade pieces of paper. The Fed now claims $1,000,000 in new assets, because it is assumed the government, with its power to tax, will make good on its debt. The government deposits the check in its own account. The check, drawn on the Federal Reserve, is considered to be good, because remember, the Fed has $1,000,000 in new assets.
- The government hires employees and buys things with the $1,000,000, and it does so by writing government checks. These government checks are then deposited in commercial banks. For the sake of simplicity, assume it all goes into one commercial bank, which has a zero balance to begin with.
- The commercial bank now claims $1,000,000 in new assets. The new assets are renamed. Instead of assets, they are now called reserves. According to the rules, this bank is allowed to lend out 90% of this new money (i.e. a 10% reserve ratio).
- $900,000 is loaned out on Friday for someone to buy a house. This loan is in the form of a check. The home buyer signs the check and gives it to the seller, who deposits it right back into the bank on Monday.
- The commercial bank now claims $900,000 in new assets. These assets are renamed reserves, and 90% of that, or $810,000 is loaned out. As soon as the $810,000 is deposited back into the bank, you guessed it, the cycle repeats and repeats until there is no more money to lend.
- The total amount lent out to borrowers is $9,000,000. Add that to the $1,000,000 that it still has on deposit and the total is $10,000,000 of new money. 6% interest on $9,000,000 is $540,000 per year. Recall the bank began the example with a zero balance.
7 Further reading
- Greider, William (1987). Secrets of the Temple. Simon & Schuster. BooksEnthsiast.com; a book intended for lay readers explaining the structures, functions, and history of the Federal Reserve.
- Epstein, Lita & Martin, Preston (2003). The Complete Idiot's Guide to the Federal Reserve. Alpha Books. BooksEnthsiast.com.
- Meyer, Lawrence H (2004). A Term at the Fed : An Insider's View. HarperBusiness. BooksEnthsiast.com.
- Rothbard, Murray N. (1994). The Case Against the Fed. Ludwig Von Mises Institute. BooksEnthsiast.com.
8 See also
9 External links
United States federal agencies Central banks Banks of the United States
