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The Federal Reserve uses tools it calls Open Market Operations, Interest on Reserve Balances, its Discount Window rate, and the rate at its Overnight Reverse Repurchase Agreement Facility to inject or remove money from the supply and influence interest rates, which encourages or discourages lending between banks, and between banks and customers, where most money is created.
Key Takeaways
- The Federal Reserve, as America’s central bank, is responsible for controlling the supply of U.S. dollars.
- The Fed purchases securities on the open market and adds the corresponding funds to the bank reserves of commercial banks, who create more money by lending it.
- It can also sell securities, which takes money out of circulation.
- The Fed sets a target federal funds rate range using the rates of other tools to affect interest rates throughout the economy and adjust the rate of money creation.
Open Market Operations (OMO)
The Fed uses open market operations (OMO), where it buys or borrows existing bonds on the open market from commercial banks and other financial institutions. When the central bank buys bonds, it pays for them by adding cash to the reserve accounts of member banks. These transfers increase the amount of money circulating.
Conversely, the Fed can sell or lend bonds to banks. It removes money from member banks’ reserve accounts and transfers the bonds to them, removing money from circulation.
The Discount Window Rate
The Federal Reserve acts as the lender of last resort for commercial banks in the U.S. It hosts facilities in each of its Reserve Banks called discount windows, where banks can go to take out loans. There are three interest rates banks might pay at these windows: a primary rate, a secondary rate, and a seasonal rate.
The primary rate is charged to the most creditworthy banks. It is called the discount window rate regarding setting the target rate range that the Fed wants to keep the federal funds rate within.
Overnight Reverse Repurchases (ON RRP)
The Federal Reserve uses repurchase agreements as another way to keep the federal funds rate within its target rate range. The Fed can buy (repurchase) bonds from banks with the intent to sell them back to them at a later date for a higher price. It can also sell bonds to banks (reverse repurchase) with the intent to buy them back at a later date for a higher price.
Important
The Overnight Reverse Repurchase rate helps the Fed keep the federal funds rate within the lower bound of its target rate range.
Interest on Reserve Balances (IORB)
Commercial banks are no longer required to maintain reserve balances at the Fed. However, they are incentivized to do so because the Fed pays them interest on the amount they hold in reserve. This interest is credited to the banks’ reserve accounts, essentially creating money. The banks can then use this money in loans, which creates more money.
IORB is the primary tool the Fed uses to keep the federal funds rate within the target rate range. The central bank sets the IORB rate so that banks must decide whether lending money to other banks or leaving funds in their reserve accounts and generating interest income is more profitable.
The Federal Funds Target Rate Range
The Federal Funds Rate, as it was known prior to 2019, was an interest rate set by the Fed as a rate for banks to use when initiating overnight loans from excess reserves. The Fed transitioned from a regime of abundant reserves to one of ample reserves, changing how the Federal Funds Rate was determined.
To encourage banks to lend to each other, and to affect how money is created, the Fed publishes a target rate range derived from the discount rate and the ON RRP rate. The rates for IORB, the discount window, and ON RPP (collectively called the administered rates) are set to keep the federal funds rate from exceeding or falling below the rate boundaries set by the Fed and encourage banks to act the way the Fed wants them to.
The Federal Funds Effective Rate is calculated using a weighted average of the rates banks charge each other overnight. It’s used by banks as a guide for all other interest rates, and it also helps dictate how much money is being created.
Does the Fed Create New Money?
Yes, but the Fed does not print paper money. That is handled by the Treasury Department’s Bureau of Engraving and Printing. The U.S. Mint produces the country’s coins.
Does the Fed Make a Profit?
No. The Fed earns interest on securities held and through fees. Once it pays its expenses, it turns over all remaining funds to the U.S. Treasury.
Does the Federal Reserve Create the Federal Budget?
No. The federal budget is created by Congress and the president. The Federal Reserve focuses on monetary policy.
The Bottom Line
The Federal Reserve creates money when it decides that the economy would benefit from it. It does not print currency but adds funds to the money supply by changing the Fed funds target rate range to affect other interest rates. It may also buy Treasury securities on the open market to add funds to bank reserves. Banks create money by lending surplus reserves to consumers and businesses. This, in turn, ultimately adds more to circulating money as funds are deposited and loaned again.
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