Dear Mr. Econ… Tackling the Federal Reserve

Illustration by Karrie Lyons-Munkittrick

I am glad to see a column dealing with economics started in the Iguana.

Sometimes people accuse the Federal Reserve of printing money, but I believe it is the Treasury that actually prints money, while the Federal Reserve influences interest rates and money supply by setting reserve requirements for banks.

I would be interested in hearing an explanation about how the U.S. government creates money as a general topic. But my specific question is where did the Federal Reserve get the money to go into the market and buy mortgage-backed securities that it probably is still holding? I never knew that the Federal Reserve had its own money to use.

–  Goldie Schwartz

Dear GS:

What a great question! Especially in this election year, there have been so many misrepresentations about the role of the Federal Reserve System of the U.S. (the Fed). Your question provides a great opportunity for Mr. Econ to present the facts to all Gainesville Iguana readers.

Let me start by setting the record straight on who prints and mints money here in the U.S. The printing of paper money is done by the U.S. Department of Treasury’s Bureau of Printing and Engraving. Coins are minted by the U.S. Treasury’s Bureau of the Mint. The Federal Reserve System, including its 12 regional banks and all of its member banks, does not print money. So you are correct on this point.

The Federal Reserve System does play an important part in the distribution of money. The Fed purchases money from the U.S. Treasury, and through its operations and those of its regional and member banks, money is distributed throughout the nation. This is one of the ways the Fed makes money. The Fed purchases coins from the Treasury at face value. Paper money, however, is purchased at the cost of production, and “sold” to the Fed’s regional and member banks at face value. This results in a small profit for the Federal Reserve System.

The Fed is self-financing. In fact, in the past two years, it has returned a combined total of $156 billion to the U.S. Treasury. The Fed is required to return all profits from its activities to the Treasury, with the exception of a 6 percent dividend paid to member banks on their capital investment in the Fed and funds that are needed to maintain an account surplus.

So if only a small amount of its funds come from selling money, where you ask, does the rest of the money come from?

The Federal Reserve System Act requires the Fed to accomplish three objectives: full employment, stabile prices and moderate long-term interest rates. In addition, the Federal Reserve conducts the nation’s monetary policy; supervises and regulates banking institutions to ensure the safety and soundness of the nation’s banking and financial system; protects the credit rights of consumers; maintains the stability of the financial system; contains systemic risk that may arise in financial markets; and  provides financial services to depository institutions, the U.S. government and foreign official institutions, including playing a major role in operating the nation’s payments system.

It is from carrying out these activities that the Fed makes money.

First, if you think of the Fed as the bank for the U.S. government and for all of the other banks in the country, you begin to see how the Fed makes money. Just like your bank or credit union, the Fed charges for the services it provides. If a member bank needs a loan, the Fed loans the bank money and collects interest on the loan. If a bank’s depositor writes a check that is deposited in another financial institution, the Fed, and its regional banks, provides what is known as the “clearing house service” for a fee.

The Federal Reserve is supposed to act to keep the U.S. economy growing at a steady pace. One of the ways it does this is through its “Open Market Operations.” Directed by the Federal Open Market Committee (FOMC), the Fed loosens or tightens up the availability of credit, and increases or decreases the money supply in the economy. The Fed does this by setting two key interest rates, the Discount Rate and the Federal Funds Rate, and by adding money to the economy or pulling money out of circulation through the buying or selling of U.S. Government securities – mostly U.S. Treasury Bill and Notes and U.S. Savings Bonds on the “open market.”

Another way the Fed takes in money is through the sale of its own stock. In order for a bank to become a member of the Federal Reserve System, it must meet certain financial solvency requirements and purchase stock in the Federal Reserve Bank equal to 3 percent of it combined capital and surplus.

The other source of funds is the “reserves” the member banks deposit with the Fed. This is also where the name for the Federal Reserve System comes from. Banks are required to keep reserves on deposit with the Fed as sort of back-up savings or “rainy day accounts” in the event a member bank runs into trouble. The Fed changes the reserve requirements to help stabilize the economy. If the Fed believes the economy is growing too slowly or not at all, it can reduce reserve requirements, thus allowing banks to circulate more money. On the other hand, if there is too much money circulating and inflation is a problem, the Fed can up the reserve requirement, thus taking capital that would have been available for lending and investment out of circulation to “cool” the economy. Member banks are paid interest on the reserves deposited with the Fed.

I hope this answers your question and gives you and all of our readers a better understanding of the Federal Reserve System and just what it is supposed to do. I’ll have to leave the topic of how money is created, why the Fed chose to purchase mortgage-backed securities, and a general history of how and why the Fed was created for another column.

Thank you again for your letter.  I look forward to receiving more letters from our readers. 

Mr. Econ is a new regular column in the Iguana where readers submit their tough questions about the economy and financial system to In the next issue, Mr. Econ will answer your questions in plain English!

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