The Fed or Banks?

by Jim Berger, 6/2008
Updated 10/2025

Update

I posted this article on a different channel in 2008. I decided to update and republish the content today, October 10, 2025. This article runs quite a bit longer than most of my publications. In addition, I have placed some rather technical modeling at the end. I want readers to know that I have examined the popular misunderstanding that The Fed makes “money” for many years.

I wrote this article before The Fed lowered the Reserve requirement to zero.

An Assertion

I have asserted on occasion that commercial banks, not the central bank, actually expand the money supply. This simple statement has met with a bit of disbelief in some quarters, so I will explain the rationale behind that statement.

Before I begin, I need to make my statement a little more precise: “In the reserve banking system of the United States, the commercial banks, not the central bank (The Federal Reserve Banks), actually expand the money supply.” My comments refer only to the U.S. banking system and the Federal Reserve System (The Fed), a point that seemed clear within the context of my previous statements.

Intent

To support this assertion, I will:

1. Define money.
2. Explain the creation of transaction dollars in Transaction Accounts and why transaction dollars fit the definition of money.
3. Explain the creation of reserve dollars in Reserve Accounts and why reserve dollars do not fit the definition of money.
4. Explain the relationship between Transaction Accounts and Reserve Accounts.
5. Explain The Fed’s Influence on Transaction Accounts based on the relationship between Transaction Accounts and Reserve Accounts.
6. Describe why currency acts as either transaction dollars or reserve dollars, depending on its use.
   

Money Defined

We cannot determine who creates money until we have a clear definition of the word “money.”

Money consists of any economic good, or any claim on such a good, that serves as a general medium of exchange and that acts as a final means of payment.

A “good” consists of any property that satisfies a human need. A good becomes an “economic good” if the quantity available will not satisfy all of those needs. (See Principles of Economics by Carl Menger) In this digital age, unique and secure information can exist as an economic good.

An economic good functions as a “general medium of exchange” if traders widely accept it for indirect exchange. Traders who accept the medium of exchange as payment must have confidence that others will willingly accept it for further transactions.

To serve as money, a good must not require further conversion or additional transactions after a trader has accepted it in payment. Credit cards, for example, would not qualify as money. Credit cards create a debt for the payee that requires repayment—an additional transaction. A bearer bond (payable to anyone who possesses it) would also not qualify. It requires conversions for final payment.

Transaction Accounts

The creation of money, like most economic activities, begins with the consumer.

Imagine that you need to borrow $300,000 for some purpose. If the banker agrees to make the loan, you sign a note that obliges you to pay back the $300,000 at some time in the future, with interest. That note, or more specifically, your obligation, now becomes an asset of the bank.

In exchange for your note, the banker hands you a receipt that says you now have $300,000 in your checking account. (Modern bank lingo now calls that a transaction account.) You can now buy that boat, racehorse, or invest in your business—or whatever you told the banker.

Does that ledger entry in your account qualify as money?

Yes, your transaction account, like those in banks across the country, does fit the definition of money. It gives you a claim that you can use as a general medium of indirect exchange, and it serves as a final means of payment. I will refer to the balances in Transaction Accounts as “Transaction Dollars,” “T-Dollars,” or “(T$).”

What did the banker need to make that credit to your account?

Before the banker handed you that receipt, he did not have to check his inventory of paper dollars, pennies, or gold bars. He simply made an entry in his ledger to indicate the bank now owed you, or anyone to whom you wrote a check, $300,000 (or T$300,000). He created money out of thin air.

Doesn’t this process create money without limit?

It could. This same process occurs through out the banking system. So, it would seem, as long as customers demanded loan funds, banks could accept customer notes and create money without limit.

I have provided System Dynamics models at the end of this paper to help demonstrate the effects that I describe here.

Reserve Accounts

Banks, however, do have limits as to the amount of money they can create. I will explain that limit after explaining another type of account on bank balance sheets.

Reserve Accounts: Defined

Most large commercial banks belong to the Federal Reserve System. The Fed requires that “member” banks have Reserve Accounts with The Fed (Reserve Accounts @ Fed). (Generally, non-member banks must have Reserve Accounts with member banks because of various banking regulations. My comments about Reserve Accounts, therefore, apply nearly universally in the U.S. banking system.)

The balances in the Reserve Accounts on the balance sheets of member banks represent assets for those banks. The balances in the Reserve Accounts on the balance sheet of The Federal Reserve represent liabilities of the Federal Reserve to the member banks. When I refer to “Reserve Accounts,” I generally mean the asset accounts of member banks; however, since the debit entries on the books of member banks mirror the credit entries on the books of The Fed, “Reserve Accounts” applies to both the liabilities of The Fed and the assets of member banks.

To distinguish balances in Reserve Accounts (either for the banks or The Fed) from balances in Transaction Accounts, I will refer to them as “Reserve Dollars,” “R-Dollars” or “(R$).”

Reserve Accounts: Description

Two types of transactions affect Reserve Account balances: 1) Inter-Bank Transactions and 2) Transactions with The Fed.

The two more widely recognized inter-bank transactions consist of check clearing and Fed Funds transactions. These transactions, however, only involve transferring reserve balances from one member bank to another. They neither increase nor decrease total bank reserves (R-Dollars) in the banking system, nor do they involve the aggregate Transaction Account Balances (T-Dollars) of commercial banks. For those reasons, I will not elaborate on the details of those transactions here.

Two specific transactions with The Fed—The Fed Discount Window and Fed Open Market Operations— do, on the other hand, cause changes in the balances of Reserve Accounts. I will describe these transactions later in this paper.

Member banks cannot use R-Dollars for transactions outside the Federal Reserve System, such as paying bank expenses or funding bank loans. Therefore, although R-Dollars do act as media of exchange and as a final means of payment, banks do not—and consumers cannot—use them as a widely accepted medium of indirect exchange. Balances in Reserve Accounts (R-Dollars), therefore, do not qualify as money.

Find the System Dynamics model for Reserve Accounts at the bottom.

The Relationship: T-Dollars to R-Dollars

What relationship do Transaction Accounts (T-Dollars) and Reserve Accounts (R-Dollars) have with each other?

In the section on Transaction Accounts, I mentioned that banks, even though they create money at will when making loans, cannot create money without limit. The relationship of Reserve Accounts to the Transaction Accounts—as determined by “Required Reserves”—acts as a regulator for the amount of money banks can create.

Federal Reserve regulations require that member banks maintain a minimum ratio between their Reserve Account balances (R-Dollars) and their Transaction Account balances (T-Dollars). The current reserve ratio amounts to 1:10—i.e., member banks must have at least one R-Dollar (R$1.00) on account with The Fed for every ten T-Dollars (T$10.00) in Transaction Account balances. If a bank has too few R-Dollars on account, it must make up the deficit in a number of ways that returns the ratio to R$1.00 of Reserve Account balances for each T$10.00 of T-Account balances. (Since this paper deals with expansion, I will not cover the details of how they can deal with Reserve Account deficits.)

Any reserve balances above the required reserve ratio represent “excess reserves.” To make your loan and create T$300,000 for you, your bank should have at least R$30,000 in excess reserves in its Reserve Account. Because of the dynamic nature of the banking system, an individual banker really does not need to check the Reserve Account balance to make a relatively small loan. If the bank ends up short R$30,000 in the Reserve Account at the end of the calculation period, it will simply buy Fed Funds from another bank.

The aggregate amount of excess reserves at a particular time determines the potential monetary expansion for the whole banking system. If all member banks have T$400 billion in Transaction Accounts and R$50 billion in Reserve Accounts at Fed balances, they have T$10 billion in excess reserves. They have the potential to expand the money supply by close to T$100 billion.

Find a model showing the relationship of T-Dollars to R-Dollars near the bottom.

The Fed’s Influence on Money Creation

So, if that’s the relationship between T-Dollars and R-Dollars, what role does The Fed play in influencing the money supply?

Since the quantity of excess reserves (R-Dollars) regulates the quantity of T-Dollars banks can create, The Fed influences the creation of money (T-Dollars) by influencing the quantity of excess reserves. (NOTE: I use the word “influence” rather than “cause” or “control” because The Fed cannot force any of these results to occur.)

Influencing Excess Reserves

The Fed uses three processes to influence the increase of excess reserves: 1) reducing the Fractional Reserve Requirement; 2) the Discount Window; and 3) the Open Market Operations.

Each of these three operations by The Fed creates additional excess reserves for member banks. Only two—the discount window and open market operations—create new R-Dollars. Only open market operations have the potential to cause the creation of new T-Dollars—but not by The Fed. I will explain the creation of T-Dollars as a result of open market operations below.

Fractional Reserve Requirement

The most powerful, yet infrequently used, process for increasing excess reserves consists of reducing the Fractional Reserve Ratio. If The Fed lowered the Fractional Reserve Ratio, that action by itself would not create a single R-Dollar of additional bank reserves. It would, however, convert billions of R-Dollars in the Reserve Accounts into excess reserves because the required reserve amount would decrease while actual reserve balances remained the same.

Discount Window

The discount window refers to the process by which The Fed makes loans to its member banks. The process operates in a manner similar to a customer borrowing from commercial banks. The bank obliges itself to repay the loan, while The Fed simply makes a ledger entry increasing the borrowing bank’s Reserve Account—creating R-Dollars from thin air—and thereby increasing excess reserves. The discount window, however, plays a minor role in increasing bank reserves. In addition, since the banks must repay these loans in a relatively short period, this process does not cause a long-term increase in R-Dollars.

Open Market Operations

The Open Market operations of The Fed play the most significant role in R-Dollar creation. The Fed purchases government securities from the open market through a number of banks and broker-dealers, which act as “primary dealers” for The Fed. The Fed pays for these purchases by adding to Reserve Accounts—creating new R-Dollars.

When a bank acts as a primary dealer in an open market purchase by The Fed, The Fed adds R-Dollars to its Reserve Account, which completes the transaction.

When a broker-dealer acts as primary dealer, The Fed adds to the Reserve Account (R-Dollars) of the broker-dealer’s bank. The bank, in turn, credits the broker-dealer’s Transaction Account with an equal number of T-Dollars. In this last instance, when the bank credits the broker-dealer’s Transaction Account, the bank creates new T-Dollars. With a reserve ratio of 1R-Dollar to 10T-Dollars, 9 of every 10 R-Dollars added to the Reserve Account for that transaction become excess reserves.

Effects of Additional Excess Reserves

So, what effect do additional excess reserves (R-Dollars) have on the creation of new money (T-Dollars)?

None.

Yes, by itself, the creation of more excess reserves (R-Dollars) does not expand the T-Dollars supply. Having those excess reserves simply gives the banks the latitude to make more loans, which they fund with new T-Dollars. The banks create no new T-Dollars until customers “borrow.”

Typically, banks never lack potential borrowers. Thus, when the excess reserves (R-Dollars) increase, we tend to see a rapid increase in T-Dollars. This correlation gives many people, including those at The Fed, the idea that The Fed controls the creation of T-Dollars, but they do not. Again, The Fed only influences the creation of T-Dollars (money).

The graphs at the end of this publication show the effects of additional excess reserve based on the preceding model.

A Loose End: Currency

I have not mentioned currency until now because currency tends to confuse people a little. At one time, the $10.00 bill (or the $100.00 bill) that you have in your wallet occupied space in a Federal Reserve vault. It also has “Federal Reserve Note” printed on it. And, since you can spend it nearly anywhere, it fits the definition of money.

So, don’t those facts confirm that The Fed creates money?

Like any good, the “goods” characteristic of currency results from its use, not from some inherent property. A good becomes money when people use it as money. The question, therefore, becomes, “What entity places Federal Reserve Notes into use as money first? The Fed? Banks?”

Uncirculated currency in The Fed vaults does not qualify as money, for it has never served the purpose of a general medium of exchange. The Fed then only transfers new currency to its member banks. It does not deal with the public. While still in the bank’s vault—referred to as “Vault Cash”—The Fed continues to count it as part of required reserves (R-Dollars)—still not money. When the bank removes the currency from its vault, it then becomes part of “Currency in Circulation”—or part of the money supply (T-Dollars).

Summary

I started with the definition that “money consists of any economic good, or any claim on such a good, that serves as a general medium of exchange and that acts as a final means of payment.” I then constructed a logical argument that supports my assertion that “in the reserve banking system of the United States, the commercial banks, not the central bank (The Federal Reserve Banks), actually expand the money supply.” I have focused the discussion on the Transaction Accounts and Reserve Accounts of Banks because these two types of accounts provide sufficient evidence to support my case.

First, banks make credit entries to Transaction Accounts (I refer to these as T-Dollars) in return for debt obligations. Transaction Accounts (T-Dollars) meet all three qualifications of money based on the definition.

Second, banks make debit entries to their Reserve Accounts to reflect the credit entries made by The Fed to the banks’ Reserve Accounts at The Fed (I refer to these as R-Dollars). Reserve Accounts (R-Dollars) fail to meet the qualification of money based on the definition because they do not act as a general medium of exchange.

Third, the mandated requirement that banks maintain a specific ratio of R-Dollars in their Reserve Accounts to T-Dollars in their Transaction Accounts (Required Fractional Reserve Ratio) establishes the relationship between these accounts. The quantity of R-Dollars, as a result of this reserve requirement, serves as the regulator for the quantity of T-Dollars the banks can create.

Fourth, The Fed transacts all of its business in R-Dollars; it does not create or deal in T-Dollars. The Fed exercises all of its influence through the relationship of T-Dollars to R-Dollars established by the reserve requirement. By increasing excess reserves (in R-Dollars) through its three tools, the Fed only gives the banks the capacity to create more T-Dollars (more money).

Fifth, the same physical currency can act as either R-Dollars or T-Dollars, depending on use and location. Vault Cash counts in the reserve requirement and acts as R-Dollars. Currency in Circulation acts as T-Dollars (money). Since The Fed only transfers currency to and from banks as R-Dollars and only banks issue currency as T-Dollars to customers, I argue that The Fed’s “printing” of currency does not entail monetary expansion by itself. (Remember the Bureau of Printing and Engraving actually prints Federal Reserve Notes. No one accuses them of expanding the money supply.)

Conclusion

The Fed only transacts business through Reserve Accounts (R-Dollars) and only takes actions that affect Reserve Accounts (R-Dollars). Therefore, because Reserve Accounts (R-Dollars) do not qualify as money, The Fed does not, unilaterally, expand the money supply. The Fed simply changes the “regulator” of monetary expansion—excess reserves. Actual expansion of the money supply—increases in Transaction Accounts (T-Dollars)—requires action on the part of member banks.

In the end, customer demand for loans plays the most important role. Without loan activity, banks would not create much money.

(In fact, banks have not made “loans” for years; they acquire debt obligations in exchange for the money they create.)

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System Dynamic Models of Monetary Expansion

I felt that graphic representations might help some readers better understand the processes that I have described above. I have used System Dynamics (or Stock and Flow) models, which show the relationships between variables and generate graphic “behavior over time” charts based on those relationships.

Although stock and flow diagrams can become extremely complex, you should have no trouble understanding these with brief explanations.

NOTE: I have used only hypothetical quantities in these models. I want to demonstrate the behavior of the system, not predict actual behavior. Also, these models apply to either individual banks or the system of member banks.

(NOTE: Words or phrases in bold italics refer to variables on the related stock and flow diagram.)

Transactions Accounts (without Reserves)

This model depicts the process of creating T-Dollars based on loan demand. This initial model shows no reserve requirement.

Stock and Flow Diagram of Transaction Accounts

The box in the center (Transaction Accounts) represents the balance in Transaction Accounts at any specific time. Those balances amount to the initial balance in Transaction Accounts plus account increases less account decreases. Account increases represent the amount added to Transaction Accounts in each time period (months). Account decreases represent the amount subtracted from Transaction Accounts in each time period (months).

Loans funded inform the system of the account balance increase each month. Loans repaid tell the system the amount of the account decreases each month. To keep the model simple, I have assumed zero (T$0.00) loans repaid, and I have modeled loans funded as the only method of account increases. Loan demand represents the monthly demand for the loan of T-Dollars. Again, for simplicity, I have assumed that 100% of loan demand gets funded.

In summary, customers request bank loans (loan demand). The bank chooses to fund those loans (loans funded) by making credit entries (account increases) to Transaction Accounts (Transaction Accounts). Since I have assumed no loan repayments (loans repaid), no reductions in Transaction Accounts occur; thus, at any time, Transaction Accounts at any time equal the initial balance plus accumulated account increases.

You can see that nothing happens without loan demand.

The graph below shows the Transaction Accounts balances resulting from two scenarios for loan demand.

Transaction Account Balances

For this model, I have assumed Transaction Accounts begin with an initial balance of T$1 Million. I have run two scenarios depicted by the graph above.

Scenario 1 (a baseline): Zero (T$0.00) loan demand, causing no change in the Transaction Accounts balance (T-Dollars) (blue line).

Scenario 2: loan demand equals T$200,000 per month, causing the Transaction Accounts balance to rise steadily over these 100 months (red line). With no regulating factor Transaction Accounts balance would continue to rise without limit.

Bank Reserve Accounts

This second model depicts the processes for the creation of R-Dollars. Since this model works basically like the Transaction Account model, I will not describe it in quite as much detail.

Stock and Flow Diagram of Bank Reserves

Similar to the Transaction Accounts model, Bank Reserves begin with an initial balance that increases and decreases based on the in and outflows (reserve increase and reserve decrease). Although I have shown the other variables that would affect reserve increase and reserve decrease, in this model, I assume only the effect of securities purchases by The Fed. (For the other variables that influence reserve increase and reserve decrease, I have assumed values of zero (R$0.00).)

Thus, when The Fed buys government bonds (securities purchases by Fed), it then adds R-Dollars to the banks’ Reserve Accounts at The Fed. The banks make mirror entries in the Bank Reserves on their own books (bank adds to reserves account) by an equivalent amount. That activity adds to the flow of reserve increase, which increases Bank Reserves.

Reserve Account Balances

In this model, I have assumed that Banks Reserves begin with an initial balance of R$1 Million. Like the Transaction Accounts model, I have run two scenarios, shown in the graph above.

Scenario 1 (a baseline): securities purchases by The Fed remain at zero (R$0.00) throughout the 100 months of this scenario. This results in no change to the Bank Reserves balance (blue line)

Scenario 2: The Fed purchases R$7,500 of securities each month (securities purchases by Fed). The banks debit their Bank Reserves account (bank adds to reserves account) to mirror the credit entries The Fed makes to the banks’ accounts with The Fed. In this scenario, Bank Reserves grow steadily throughout the period.

Relationship of Transaction Accounts to Bank Reserves
and Fed Influence on Money Creation

This third model shows the relationship of Transaction Accounts to Bank Reserves. The graphs below will show that purchases of securities by the Fed will influence (not control) balances in Transaction Accounts.

Stock and Flow Diagram of Relationship
of Bank Reserves to Transaction Accounts

In the banking system, required reserves—based on the fractional reserve requirement—determine the limit of Transaction Account balances. The excess reserves determine the banks’ current capacity to increase Transaction Account balances. The Fed can increase the capacity of banks to increase Transaction Account balances by taking actions that increase excess reserves. For this paper, I have concentrated on open market operations. I have connected the models of Transaction Accounts and Bank Reserves with the following added variables:

The model calculates required reserves by multiplying the number of T-Dollars in Transactions Accounts by the fractional reserve requirement. It then applies a conversion factor (T-Dollar to R-Dollar conversion ratio) to arrive at the number of R-Dollars required in Bank Reserves for the current number of T-Dollars in Transaction Accounts.

The model then calculates excess reserves (T-Dollars) by subtracting required reserves from Bank Reserves.

In the combined model, I reset the formula for loans funded to equal loan demand only if excess reserves exceed R$0.00. If excess reserves equal zero (R$0.00) or less, loans funded will equal T$0.00. This process regulates the creation of T-Dollars based on the level of excess R-Dollars.

After connecting the Transaction Accounts model to the Bank Reserve model in that manner, I ran the following scenarios, changing only two variables—securities purchases by Fed and loan demand:

Relationship of Bank Reserves to Transaction Accounts
Scenario 1 (Baseline)

In the first scenario, which provides a baseline, I left loan demand at T$0.00 per month and securities purchases by Fed at R$0.00 per month. Transaction Accounts and Bank Reserves remain level throughout the model period—at T$1,000,000.00 (blue line, lower scale) R$1,000,000.00 (red line, upper scale), respectively.

Relationship of Bank Reserves to Transaction Accounts
Scenario 2

In this second scenario loan demand stays constant at T$200,000 per month, and Fed Securities purchases (securities purchases by Fed) equal R$0.00 per month. As a result, Bank Reserves stay constant at R$1Million (Red Line – lower scale) and Transaction Accounts balances (T-Dollars) increase until they reach T$10M (Blue Line – Upper scale). Transaction Accounts balances level off because of the limit set by the fractional reserve requirement (R$1.00 to T$10.00).

Relationship of Bank Reserves to Transaction Accounts
Scenario 3

In this third scenario loan demand stays constant at T$0.00 per month, and Fed Securities purchases (securities purchases by Fed) equal R$7,500.00 per month. As a result, Bank Reserves rise steadily throughout the period (Red Line – lower scale) and transaction Accounts balances (T-Dollars) stay level at T$0.00 (Blue Line – Upper scale).

Transaction Accounts balances stay level because of the lack of loan demand, in spite of the increase in Reserve Accounts and a corresponding rise in excess reserves. This scenario demonstrates the lack of “control” The Fed has on monetary expansion. Without loan demand, Transaction Accounts balances don’t grow.

Relationship of Bank Reserves to Transaction Accounts
Scenario 4

In the fourth scenario—a more realistic scenario—I have combined both of the effects of scenarios 2 and 3.

Loan demand stays constant at T$200,000 per month, and Fed Securities purchases (securities purchases by Fed) equal R$7,500.00 per month. As a result, Bank Reserves rise steadily throughout the period (Red Line – lower scale). Transaction Accounts balances (T-Dollars) (Blue Line – Upper scale) increase until approximately month 71 when they reach roughly T$16M. After that, the rate of increase in Transaction Accounts balances declines because the growth in excess reserves won’t permit the same rate of increase—in spite of loan demand continuing unabated.

Summary of System Dynamic Models

Model 1: Transactions Accounts (without Reserves)

Scenario 1

Parameter: Loan demand = T$0.00/month

Result: Transaction Accounts remain level at T$1Million

Scenario 2

Parameter: Loan demand = T$200,000.00/month

Result: Transaction Accounts increase throughout the period (and would continue).

Model 2: Bank Reserve Accounts

Scenario 1

Parameter: Securities purchase by Fed = T$0.00/month

Result: Bank Reserves remain level at T$1Million

Scenario 2

Parameter: Securities purchase by Fed = T$7,500.00/month

Result: Bank Reserves increase throughout the period (and would continue).

Model 3: Combined Model

Relationship of Transaction Accounts to Bank Reserves and Fed Influence on Money Creation

Scenario 1

Parameters: Loan demand = T$0.00/month
Securities purchase by Fed = T$0.00/month

Results: Transaction Accounts and Bank Reserves remain level throughout the period.

Scenario 2

Parameters: Loan demand = T$200,000.00/month
Securities purchase by Fed = T$0.00/month

Results: Transaction Accounts rise steadily to T$10Million (limited by reserve requirements) and Bank Reserves remain level throughout the period.

Scenario 3

Parameters: Loan demand = T$0.00/month
Securities purchase by Fed = T$7,500.00/month

Results: Transaction Accounts remain level throughout the period, and Bank Reserves increase throughout the period (and would continue).

Scenario 4

Parameters: Loan demand = T$200,000.00/month
Securities purchase by Fed = T$7,500.00/month

Results: Transaction Accounts rise steadily for about 71 months to roughly T$16Million after which they increase less rapidly (limited by excess reserves). Bank Reserves increase throughout the period (and would continue).