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The purpose of this article is to explain the current implementation of monetary policy in the United States, as well as some of the financial details behind the current methods.

Money creation and money supply

When money is deposited in a bank, it can then be lent out to another person. If the initial deposit was $100 and the bank lends out $100 to another customer the money supply has increased by $100. However, because the depositor can ask for the money back, banks have to maintain minimum reserves to service customer needs. If the reserve requirement is 10% then, in the earlier example, the bank can lend $90 and thus the money supply increases by only $90. The reserve requirement therefore acts as a limit on this multiplier effect.

The money supply has different components, generally broken down into "narrow" and "broad" money. The Federal Reserve controls only the most narrow form of money, physical cash outstanding along with the reserves of banks throughout the country (known as M0 or the monetary base). Discussion of "money" often confuses the different measures and may lead to misguided commentary on monetary policy and misunderstandings of policy discussions.

Federal Reserve and Money Supply

The Federal Reserve has three main mechanisms for manipulating the money supply. It can buy or sell treasury securities. Selling securities has the effect of reducing the monetary base (because it accepts money in return for purchase of securities). Purchasing treasury securities increases the monetary base (because it pays out hard currency in exchange for accepting securities). Secondly, the discount rate can be changed. And finally, the Federal Reserve can adjust the reserve requirement, which can affect the money multiplier.

Assuming a closed economy, where foreign capital or trade does not effect the money supply, when interest rates go down, money supply increases. Businesses and consumers have a lower cost of capital and can increase spending and capital improvement projects. This encourages growth. Conversely, when interest rates go up, the money supply falls and reins in the economy. The Federal reserve increases interest rates to combat inflation.

Money creation

Currently, the US government maintains over 800 billion US dollars in cash money (primarily Federal Reserve Notes) in circulation throughout the world, whereas in 1959, there was less than 30 billion dollars; going back even further, the money supply was less than 20 billion dollars in 1933. Thus, the money supply has grown by more than 750 billion dollars since 1933. Below is an outline of the process which is currently used to control the amount of money in the economy. The amount of money in circulation generally increases to accommodate money demanded by the growth of the country's production. This monetary policy is implemented by the Federal Reserve System - the quasi-public central bank of the United States.

1. In order to raise additional money to cover excess spending, Congress increases the size of the National Debt by issuing securities typically in the form of a Treasury Bond (see Treasury security). It offers the Treasury security for sale, and someone pays cash to the government in exchange. Banks are often the purchasers of these securities.
2. The 12-person Federal Open Market Committee, that consist of the heads of the Federal Reserve System, meets eight times a year to determine how they would like to influence the economy. They create a plan called the country's "monetary policy" which sets targets for things such as interest rates.
3. Banks go through their daily transactions. Of the total money deposited at banks, significant and predictable proportions often remain deposited, and may be referred to as "core deposits." Banks decide to make use of the bulk of "non-moving" money (their stable deposit base) by loaning it out. Banks have a legal requirement to keep a certain percentage of money on-hand at all times.
4. According to the estimates in its plan for the US Economy, the Federal Reserve places an order for money with the US Treasury Department. The Treasury Department sends these requests to its operations called the Bureau of Engraving and Printing (to make dollar bills) and the Bureau of the Mint (to stamp the coins).
5. The US Treasury sells this newly printed money to the Federal Reserve for the cost of printing. This is about 6 cents per bill for any denomination. Aside from printing costs, the Federal Reserve must pledge collateral (typically government securities such as Treasury bonds) to put new money, which does not replace old notes, into circulation.
6. Every business day, the Federal Reserve System engages in Open market operations. If the Federal Reserve wants to increase the money supply, it will buy securities (such as US Treasury Bonds) from the banks in exchange for dollars. If the Federal Reserve wants to decrease the money supply, it will sell securities to the banks in exchange for dollars.
7. By means of open market operations, the Federal Reserve affects the free reserves of commercial banks in the country. Anna Schwartz explains that "if the Federal Reserve increases reserves, a single bank can make loans up to the amount of its excess reserves, creating an equal amount of deposits".
8. Since banks have more free reserves, they may loan out the money, because holding the money would amount to accepting the cost of foregone interest and commercial banks generally act to avoid such opportunity costs. When a loan is granted, a person is generally granted the money by adding to the balance on their bank account. As a Superintendent of Maine's Department of Banks and Banking once explained, "a commercial bank is able to make a loan by simply creating a new demand deposit (so called checkbook money) through bookkeeping entry."
9. This is how additional money is placed into the hands of the public --- through bank loans; as written in a particular case study, "as banks increase or decrease loans, the nation's money supply increases or decreases." Once granted these additional funds, the recipient has the option to withdraw physical currency (dollar bills and coins) from the bank.

It should be noted that the Federal Reserve distributes and the Treasury creates cash, but money is created by commercial banks through the money multiplier mechanism. One textbook summarizes the process as follows:

"The Fed" controls the money supply in the United States by controlling the amount of loans made by commercial banks. New loans are usually in the form of increased checking account balances, and since checkable deposits are part of the money supply, the money supply increases when new loans are made ...

Basic economics also teaches that money is destroyed when loans are repaid; however, the money supply will not necessarily decrease. Other than loans, investment activities of commercial banks and the Federal Reserve also increase and decrease the money supply. This type of money is convertible into cash when depositors request cash withdrawals. Ecological Economist, Herman Daly, explains that most of the basic money supply in the United States also requires a cost in order to be maintained;, although Daly's correlation between GDP growth and money has been criticized by Miller, an Ecological Economist who contends that the change in money supply is due to demand which may justify its cost.For the vast majority of US money in circulation, each dollar throughout the world represents a current outstanding loan of a citizen to some bank.

measured by M1 statistics --see reference

Though the Federal Reserve Banks are private corporations, the Board of Governors which directs them is composed of seven Federal employees, whom are required to be independent of the banking sector.

Economists broadly agree that commercial banks affect the money supply through their ability to create money by lending.

see references Checking account balances at US banks similarly represent the result of a bank loan. Also a very small amount of US currency still exists as "United States Notes", which differ from the money created by the Federal Reserve System. The official designation for the currency distributed by the Federal Reserve are "Federal Reserve Notes."

Monetary policy

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The current economic process uses Treasury Securities which only exist when the nation is in debt. In 2005, the Federal Reserve held approximately 9% of the national debt in order to support the monetary base. Experts are hopeful that other assets could take the place of National Debt as the fundamental basis, and Alan Greenspan, long the head of the Federal Reserve, has been quoted as saying, "I am confident that U.S. financial markets, which are the most innovative and efficient in the world, can readily adapt to a paydown of Treasury debt by creating private alternatives with many of the attributes that market participants value in Treasury securities."

There are costs associated with maintaining the money that is printed by the government, although the US government receives income overall from seigniorage. Ecological economist, Herman Daly, explains "Over 95% of our money supply is created by the private banking system (demand deposits) and bears interest as a condition of its existence." The interest costs are owed by those that have borrowed from US banks for their loan--the loan is required in order for money to be injected into the economy, and even simply for existing money to be maintained (as noted in "Step 9" in the above process).

Growth of the supply of money in the US must be matched with an equal amount of interest-bearing debt in the country. This concept is referred to as a "staggering thought" in a book by noted economist, Irving Fisher.

If the total amount of loans were repaid to banks, then the money supply would shrink. These important steps appear to widely misunderstood, according to the volume of literature on topics such as "Federal Reserve conspiracy" and "Federal Reserve fraud."

Opinions of the Federal Reserve

The Federal Reserve is lauded by some economists, while being the target of scathing criticism by other economists, legislators, and sometimes members of the general public. The current Chairman of the Federal Reserve Board, Ben Bernanke, is one of the leading academic critics of the Federal Reserve's policies during the Great Depression.

Historic Accolades

One of the functions of a central bank is to facilitate the transfer of funds through the economy, and the Federal Reserve System is largely responsible for the efficiency in the banking sector. There have also been specific instances which put the Federal Reserve in the spotlight of public attention. For instance, after the stock market crash in 1987, the actions of the Fed are generally believed to have aided in recovery. Also, the Federal Reserve is credited for easing tensions in the business sector with the reassurances given following the 9/11 terrorist attacks on the United States.

Criticisms

Accountability

The Federal Reserve was designed to be (to some degree) independent of the political process so that monetary policy would be insulated from demands to adjust monetary policy to support one political party or another, although ultimately the Federal Reserve Board is nominated by the President. As in many countries, the level of independence of the central bank has in practice varied over the years.

One element is that the Federal Reserve is subject to different requirements for transparency and audits, which its supporters claim is another element of the Fed's independence. Although the Federal Reserve has published independently audited financial statements since 1999, the Federal Reserve is not audited like other government agencies. Some confusion can arise because there are many types of audits, including: investigative or fraud audits; and financial audits, which are audits of accounting statements; there are also compliance, operational, and information system audits.

The Federal Reserve's annual financial statements are audited by an outside auditor. Similar to other government agencies, the Federal Reserve maintains an Office of the Inspector General, whose mandate includes conducting and supervising "independent and objective audits, investigations, inspections, evaluations, and other reviews of Board programs and operations." The Inspector General's audits and reviews are available on the Federal Reserve's website.

Additionally, one notable myth debunker documents how the Federal Reserve system is audited and cites numerous instances of independent inspection of financial documents by private accounting firms and the Government Accountability Office. This debunker's website then also lists the legal exemptions to outside audit, "Exemptions to the Scope of GAO Audits:The Government Accounting Office does not have complete access to all aspects of the Federal Reserve System. The Federal Banking Agency Audit Act (31 USCA §714) stipulates the following areas are to be excluded from GAO inspections: "(2) deliberations, decisions, or actions on monetary policy matters, including discount window operations, reserves of member banks, securities credit, interest on deposits, open market operations." The same author also can be quoted in one related article as saying "in terms of monetary policy, the most important power is ... open market operations." The GAO certainly does have the power to conduct audits, but one author noted that 'the GAO audit is extremely limited: it can only examine the Fed’s 'administrative expenses.'" As the New York Times summarized in 1989, "such transactions are now shielded from outside audit, although the Fed influences interest rates through the purchase of hundreds of billions of dollars in Treasury securities."

Despite questions of accountability, many experts still agree that insulation of monetary policy from political wrangling is in the best interest of the citizens.

Fulfilment of Goals

Another criticism is that exercise of monetary policy in the United States has not achieved consistent success in meeting the goals that have been delegated to the Federal Reserve System by Congress.

Goals of Monetary Policy

Sustainable growth, High employment, Stable prices

Throughout the period of the Federal Reserve's existence, the relative weight given to each of these goals has changed, depending on political developments. In addition, interpretations of how best to implement these goals has also changed substantially, driven by academic developments, research, and the advent of unforeseen economic and financial developments, from the Great Depression to the Second World War and the development of the Bretton Woods system, including abandonment of the Gold Standard in most major Western economies. In particular, the theories of Keynesianism and monetarism have had great influence on both the theory and implementation of monetary policy, and the "prevailing wisdom" or consensus view of the economic and financial communities has changed over the years.

1. High employment - The depression of the late 1920's is generally regarded as being the worst in the country's history, and the Federal Reserve has been criticized for monetary policy which worsened the depression..
2. Stable prices - While some economists would regard any consistent inflation as a sign of unstable prices, policymakers could be satisfied with 1 or 2%; the consensus of "price stability" constituting long-run inflation of 1-2% is, however, a relatively recent development, and a change that has occurred at other central banks throughout the world. Historic inflation has averaged a 3.4% increase annually since the establishment of the Federal Reserve, along with numerous yearly swings of 10% or more. In contrast, some research indicates that average inflation for the 250 years before the system was near zero percent, though there were likely sharper upward and downward spikes in that timeframe as compared with more recent times.
3. Sustainable growth - The growth of the economy may not be sustainable as the ability for households to save money has been on an overall decline and household debt is consistently rising.

Public Confusion

The Federal Reserve has established a library of information on their websites, however, many experts have spoken about the general level of public confusion that still exists on the subject of the economy; this lack of understanding of macroeconomic questions and monetary policy, however, exists in other countries as well. Critics of the Fed widely regard the system as being "opaque," and one of the Fed's most vehement opponents, Congressman Louis T. McFadden, even went so far as to say that "Every effort has been made by the Federal Reserve Board to conceal its powers..." There are, on the other hand, many economists who support the need for an independent central banking authority, and some have established websites that aim to clear up confusion about the economy and the Federal Reserve's operations. The Federal Reserve website itself publishes various information and instructional materials for a variety of audiences.

Artificial Influences

Though not limited to only the United States, some free market economists, especially those belonging to the Austrian School criticize the very idea of monetary policy, believing that it distorts investment. In the free market interest rates will be set by savers' time preference. If there is a high time preference this means that savers will have a strong preference for consuming goods now rather than saving for them. Thus interest rates will rise due to the low supply of savings. With low time preference interest rates will fall. The interest rates send signals to businessmen as to what is worth investing in, low interest rates will mean that more capital is invested.

Monetary policy means that the interest rates no longer represent consumer time preferences and so investments are made by businessmen with the wrong signals. Lower than market interest rates will therefore mean a higher investment than the economy desires. This will mean that there will be capital goods that have been over invested, and will need to be liquidated. This liquidation is the cause of the depression that makes for the business cycle.

See also

• Austrian School
• Debt
• Free banking
• Hard currency
• Monetarism
• Monetary policy
• Money supply
• Soft currency
• Treasury bills

References

1. http://krugman.blogs.nytimes.com/2008/01/17/great-depression-blogging/ Paul Krugman, "Great Depression Blogging," January 17, 2008: "Monetary base only gets created or destroyed through Fed actions.
2. "How Currency Gets into Circulation". Federal Reserve Bank of New York. Retrieved 2008-01-06.
3. "Money Stock Measures". Federal Reserve, Board of Governors. Retrieved 2008-01-06.
4. "Frequently Asked Questions about the Public Debt". U.S. Department of the Treasury, Bureau of the Public Debt. Retrieved 2008-01-06.
5. "The Federal Reserve's Beige Book". The Federal Reserve Bank of Minneapolis. Retrieved 2008-01-06.
6. "The Federal Reserve, Monetary Policy and the Economy". The Federal Reserve Bank of Dallas. Retrieved 2008-01-06.
7. ^ Schenk, Robert, Ph.D. "From Commodity to Bank-Debt Money". Retrieved 2008-01-07. Professor of Economics{{cite web}}: CS1 maint: multiple names: authors list (link)
8. "Reserve Requirements". Retrieved 2008-01-07.
9. "Fact Sheets: Currency & Coins". United States Department of the Treasury. Retrieved 2008-01-22.
10. "Money Facts". United States Treasury, Bureau of Engraving and Printing. Retrieved 2008-01-06.
11. Davies, Phil. "Right on Target". Retrieved 2008-01-07. Federal Reserve Bank of Minneapolis
12. ^ "Reserve Requirements". Retrieved 2008-01-10. Federal Reserve Bank of New York
13. ^ Schwartz, Anna J. "Money Supply". The Concise Encyclopedia of Economics. Retrieved 2008-01-11. If the Federal Reserve increases reserves, a single bank can make loans up to the amount of its excess reserves, creating an equal amount of deposits
14. "Open Market Operations". Federal Reserve Bank of Mew York. Retrieved 2008-01-11. Open market operations enable the Federal Reserve to affect the supply of reserve balances in the banking system.
15. "The First 90 Years of the Federal Reserve Bank of Boston". Federal Reserve Bank of Boston. Retrieved 2008-01-11. Open market operations become the primary tool for carrying out monetary policy, with discount rate and reserve requirement changes used as occasional supplements.
16. ^ Simons, Howard L. "Don't Blame (or Credit) the Fed". Retrieved 2008-01-11. The Federal Reserve's open market operations affect the level of free reserves in the banking system. It is the lending of these free reserves throughout the banking system that expands the supply of credit.
17. ^ Nichols, Dorothy M (1961). Modern Money Mechanics. Federal Reserve Bank of Chicago. p. 3. Retrieved 2008-01-11. The actual process of money creation takes place primarily in banks.(1) As noted earlier, checkable liabilities of banks are money. These liabilities are customers' accounts. They increase when customers deposit currency and checks and when the proceeds of loans made by the banks are credited to borrowers' accounts. {{cite book}}: |archive-url= requires |archive-date= (help); Unknown parameter |archicedate= ignored (help); Unknown parameter |month= ignored (help)
18. ^ "A Case Study: The Federal Reserve System and Monetary Policy". Retrieved 2008-01-11. As banks increase or decrease loans, the nation's money supply increases or decreases.
19. ^ "MONEY MULTIPLIER". Retrieved 2008-01-11. ... borrowers are also inclined to convert checkable deposits into currency.
20. Mings, Turley; Marlin, Matthew, The Study of Economics: Principles, Concepts & Applications (Sixth Edition ed.), The McGraw-Hill Companies {{citation}}: |edition= has extra text (help)
21. Everett, Ray, Dr, ECONOMICS: THEORY AND PRACTICE (Seventh ed.), John Wiley & Sons, Inc, retrieved 2008-01-11{{citation}}: CS1 maint: multiple names: authors list (link)
22. Cacy, J. A. (1976). "Commerical Bank Loans and the Money Supply" (pdf). Monthly Review. Federal Reserve Bank of Kansas City. p. 3. Retrieved 2008-01-25. Bank lending, however, is only one of several sources of potential increase in the narrowly defined money supply. Another source is the investing activity of commercial banks. As in the case of loans, when banks acquire investments, such as U.S. Government securities, the public may use the proceeds to augment its M1 balances. A third source of potential increase in money balances is the asset-acquiring activities of the Federal Reserve System. When the Federal Reserve buys U.S. Government securities, the proceeds potentially may be used by the public to add to its M1 balances. {{cite web}}: Unknown parameter |month= ignored (help)
23. Cunningham, Steve, Ph.D, ECON 111 Principles of Macroeconomics: Lecture Notes, Kent State University, archived from the original on 2008-01-07, retrieved 2008-01-07{{citation}}: CS1 maint: multiple names: authors list (link)
24. ^ Daly, Herman. "Ecological Economics: The Concept of Scale and Its Relation to Allocation, Distribution, and Uneconomic Growth" (PDF). University of Maryland. Archived from the original (PDF) on 2008-01-11. Retrieved 2008-01-11.
25. Miller, Eric (2004), A Treatise on the Ecological Economics of Money (pdf), York University, p. 72, retrieved 2008-01-26 {{citation}}: Unknown parameter |day= ignored (help); Unknown parameter |month= ignored (help)
26. Upton, Ph.D, Charles W; Chase, Greg, Principles of Macroeconomics: Lecture Notes, Kent State University, retrieved 2008-01-07
27. "Is the Federal Reserve a privately owned corporation?". Federal Reserve Bank of San Francisco. Retrieved 2008-01-12. the 12 Federal Reserve Banks are chartered as private corporations
28. "Court Rules Federal Reserve is Privately Owned". Retrieved 2008-01-06.
29. "Frequently Asked Questions: board of governors". Federal Reserve Bank of Richmond. Retrieved 2008-01-06.
30. Schenk, Robert E., Ph.D. "From Commodity to Bank-Debt Money". Retrieved 2008-01-11. Money creation was a by-product of the making of the loan.{{cite web}}: CS1 maint: multiple names: authors list (link)
31. Perelman, Michael. "The neglected economics of trust". American Journal of Economics and Sociology, The, Oct, 1998. Retrieved 2008-01-06. The bank hath benefit of all the interest on all moneys which it creates out of nothing
32. Roy, Udayan. "Introduction to Economics". Long Island University. Archived from the original on 2008-01-12. Retrieved 2008-01-12. Ultimately all of the newly printed cash must end up as required reserves.
33. "How Currency Gets into Circulation". Federal Reserve Bank of New York. Retrieved 2008-01-11. Virtually all of currency notes in use are Federal Reserve notes.
34. "Who are the largest holders of U.S. public debt?". Federal Reserve Bank of San Francisco. Retrieved 2008-01-06.
35. "What will happen to the Fed if the national debt is paid off?". Federal Reserve Bank of San Francisco. Retrieved 2008-01-06.
36. Schmitt, Elizabeth Dunne. "Myths vs. Realties for the United States Federal Reserve System". Retrieved 2008-01-09. Professor of Economics
37. "Financial Instability and the Federal Reserve as a Liquidity Provider". Retrieved 2008-01-06.
38. http://www.nytimes.com/2008/01/20/magazine/20Ben-Bernanke-t.html?hp=&pagewanted=all New York Times Magazine, "The Education of Ben Bernanke", January 20, 2008.
39. http://www.federalreserve.gov/oig/oig_mission.htm
40. http://www.federalreserve.gov/oig/oig_rpt_2007.htm
41. "THE FEDERAL RESERVE BOARD (Senate - March 26, 1996)". Retrieved 2008-01-06.
42. Flaherty, Edward, Ph.D. "Myth #6: The Federal Reserve has never been audited". Retrieved 2008-01-06. Professor of Economics{{cite web}}: CS1 maint: multiple names: authors list (link)
43. Mitchell, Joseph Pershing. "The Central Bankers: Administrative Legitimacy and the Federal Reserve System". Virginia Polytechnic Institute and State University. pp. pg 142. Retrieved 2008-01-06. {{cite web}}: |pages= has extra text (help)
44. UCHITELLE, LOUIS. "Moves On in Congress to Lift Secrecy at the Federal Reserve". New York Times. Archived from the original on 2008-01-15. Retrieved 2008-01-06.
45. Woodward, G. Thomas. "Money and the Federal Reserve System". Retrieved 2008-01-07. Specialist in Macroeconomics, Congressional Research Service
46. Adams, Cecil. "Who owns the Federal Reserve?". Retrieved 2008-01-07.
47. "Monetary Policy". Federal Reserve Bank of New York. Retrieved 2008-01-06.
48. http://books.google.com/books?id=DktBcxprXaEC Allan H. Metzler, A History of the Federal Reserve.
49. Bernanke, Ben S. "Money, Gold, and the Great Depression". Federal Reserve Board. Retrieved 2008-01-06. Governor, Federal Reserve
50. "Low Inflation or No Inflation". Retrieved 2008-01-06.
51. Anderson, Richard G. "Inflation's Economic Cost: How Large? How Certain?". Retrieved 2008-01-06. Vice President, Federal Reserve Bank of St. Louis
52. "Consumer Price Index, 1913-". Federal Reserve Bank of Minneapolis. Retrieved 2008-01-06.
53. Sahr, Robert. "Inflation Conversion Factors for Dollars 1665 to Estimated 2017". Retrieved 2008-01-06. Assoc. Professor of Political Science
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55. Hodges, Michael W. "Grandfather Economic Report series". Retrieved 2008-01-06.
56. "AN ASTOUNDING EXPOSURE". Retrieved 2008-01-06.

External links

• Board of Governors of the Federal Reserve System
• Federal Reserve Bank of New York
• Savings rate viz Fed rate from 1954 Historical relationship between the savings rate and the Fed rate - since 1954
• USA Fed rate behavior under various presidencies since 1954
• Wages and Benefits: Real Wages (1964-2004)
• The Fallout from Falling US Wages
• Grandfather Economic Report series

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