Fed Funds Explained No. 1

Money Creation-Popular vs. Actual Models


A lot of confusion exists around the Fed funds market in the Fed funds interest rate. Some of this confusion comes from misunderstanding the money creation and distribution processes. In this blog post, I will contrast the popular model of money creation with the actual money creation process.

Popular Model of Money Creation & Distribution

The image I have drawn below represents what I think many people believe about how the Fed and Banks create money. I have no way to verify directly the accuracy of this model. I base it entirely on my interpretation of what people say about the Federal Reserve and its relationship with banks.

In the popular model, The Fed creates dollars (which people mistakenly call money). The Fed transfers those dollars to banks. The banks then make loans and paychecks with those dollars. When banks make loans, their deposit liabilities will increase. When banks pay checks, their deposit liabilities will decrease.

In summary, the Federal Reserve creates dollars, which get transferred to banks, and then transferred to borrowers or the payees on customer checks.

Actual Structure of Money Creation & Distribution

The Fed does create dollars, but no one can use them as money, and they do not get transferred to banks.

No one can use the dollars created by the Federal Reserve as money because only financial institutions that have accounts with the Federal Reserve have access to those dollars. The general public cannot have accounts with the Federal Reserve; therefore, Federal Reserve dollars cannot act as money.

Since the dollars created by the Federal Reserve are only accessible by financial institutions, instead of being a source of money, they counterbalance banks’ deposit liabilities. The amount by which Federal Reserve dollars counterbalance banks’ deposit liabilities depends on the reserve ratio. If, for example, the reserve ratio were 25%, for every dollar created by the Federal Reserve, banks could create four dollars.

Over the years, the reserve ratio has varied from a high of (25%) to its current level of 0%. The current reserve ratio of 0% makes it theoretically possible for banks to create an infinite amount of money dollars. Factors other than the extremely large amount of bank reserves and the 0% reserve ratio place a limit on the number of dollars that banks will create.

In this diagram, I have tried to depict what happens when a person writes a check against Bank A to a person with an account at Bank B. When that happens, Bank A transfers the same number of dollars as the amount of the check to Bank B. At the same time, Bank A reduces its deposit liabilities to Customer X, and Bank B increases its deposit liabilities to Customer Y.


I have made two points that I hope will be helpful in further discussions about Fed funds:

First, money creation does not begin with the Federal Reserve and flow through banks to their customers. Citizens cannot use dollars created by the Federal Reserve as money.

Second, dollars created by the Federal Reserve act as a sort of counterbalance to bank deposit liabilities. Depending on historical reserve ratios, banks have created several times the number of dollars held in reserves. The current reserve ratio of 0% would theoretically permit banks to create an infinite number of dollars. Other factors in the banking system, which I will discuss at another time, prevent banks from creating an unlimited supply of dollars.

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