The Fed is the marshland of the monetary system. When the Fed sees fit to increase the money supply, it buys Treasury bonds from commercial banks and deposits the cost of purchasing those bonds in the banks’ deposit accounts – no cash need be printed. They can also purchase other similar types of accounts on the open market to the same effect. But their actions are diffuse and rely on knock-on effects to achieve results. The same goes for their adjusting of the interest rate, it doesn’t mandate the rate a bank must charge on a loan to an individual, it just sets the interest rate one bank will pay another for borrowing from its reserve account.
But wait, that sounds like the Fed is doing the money creation – how can a bank do the same?
The piece of information that brings together the disparate threads we have discussed is: banks don’t only lend out the money they have reserves for, their reserves represent a mere fraction of their total debts. Put differently, if somewhat simplistically, if a bank has $10 in deposits, they’ll typically be free to lend out as much as $100. Their reserve accounts need only have 10% of their outstanding debts on hand.
So let’s look at a dollar traveling through the system. The Fed decides that $1, yes one more dollar, needs to be added to the economy and then everything will be dandy. The Fed purchases a Treasury bill from Bank X for $1, putting $1 on the deposit side of X’s ledger (remember, no physical currency is involved here). Bank X, subject to a 10% reserve requirement, is then free to lend out, that is create deposits, representing up to $10. The Fed “created” $1 but the commercial bank, X, “created” $9.
The picture becomes much clearer when one imagines an actual transaction. First, imagine a bank with no debts and no credits – a newborn baby bank. Jane Borrower takes out a mortgage with the bank to buy a house, the mortgage is for $100,000. The bank makes a deposit into the seller’s account for the purchase price, $100,000, and marks in their ledger that they have a $100,000 outstanding debt. At the end of the day, they need only have $10,000 cash on hand, which represents the 10% reserve amount they require. But where has the other $90,000 come from? It is tied up in the value of the house, which is the collateral for that loan. The bank has just converted a house, wood and nails and siding and dirt, into money.