Money Creation

There are three major creators of money in the US: the Fed, commercial banks, and the Treasury.

Federal Reserve

The Fed targets r*, when r* is below current interest rates the economy is contracting. The Fed will cut it’s overnight interest rate and engage in quantitative easing to boost the longer-dated Treasuries.

The Overnight Market Desk is the Fed’s trading arm. It’s role is into engage in market operations like quantitative easing. Additionally, it gathers market intelligence through it’s primary and secondary dealers.

The Federal reserves target rate is the federal funds rate. A more accurate target rate is the Secured Overnight Funding Rate (SOFR) which the reference rate based on overnight repo transactions secured by Treasury collateral.

Commercial Banks

Commercial banks can create money by originating loans. Loans are their assets, while deposits are their liabilities. Solvency is the issue of whether the loans backing their deposits are sound. Liquidity is an issue when the bank cannot freely convert it’s deposits into fiat currency or other assets. Solvency in a bank is managed through regulation. Liquidity can be resolved by borrowing from other banks or the Fed as a last resort.

Regulations:

  • Leverage ratio is a constraint on balance sheet based on capital. e.g. a 20X leverage rule states for $5 dollars of capital only $100 dollars of assets can be held.
  • Capital ratio is holding enough capital to match the riskiness of your investments.

Money creation by banks is limited by the investment opportunities available1.

Treasury

  • The treasury differs from the banks and Fed in that their issuance of debt is backed by nothing besides the confidence in the U.S. government1.
  • The issuance of treasury debt that is not planned on being repaid leads people to expect inflation. Yet there are examples where the debt to GDP ratio is much higher. Additionally, Treasury yields have gone down in the face of issuance.

References

1.
Wang, J. J. Central Banking 101. (Joseph, 2021).