Question

The Federal Reserve (the Fed) is the central bank of the United States with the power to create money. When the Fed decides to increase the money supply by creating more money, how do they go about doing this? What role do banks play in this process? Where does the money come from to pay for all their purchases?

Answer 1

Money creation by FED to increase money supply and role of commercial banks

Federal Reserve System is the sole authority in US to manage the money supply in economy to stabilize it.

When FED needs to increase the money supply ,it has to create money through applying various Monetary policy instruments

* Printing currency --- FED is sole authority to increase money supply by printing new currency,but is not a reliable method,brcause printing new currency leads to Inflation in the country.

* Decreasing FED discount rate--- It is the rate of interest at which a commercial bank borrows from FED. If FED Decreases this rate, the final rate of interest charged fro banks clients aldo Decreases ,ehich ultimately encourages banks to be able to kend more.

* Decreasing Reserve requirement ( SLR &CRR) Cash reserve ratio and statutory liquidity ratio ,both are required by commercial banks to maintain i,but when these ratios are decreased , the commercial banks are able to lend more money to clients.

* Buying govt securities through open market operations------ If FED buys govt bonds in open market operations, the money Reserve with commercial banks increase, which finally result in Increase in lending capacity by commercial banks.

* Quantitative Easing --- FED creates money and uses it to buy up assets and securities such as govt bonds.This money enters the banking system and Increases the banks' reserves.It further encourages banks to provide more loans.

Credit Creation process by commercial banks

The commercial banks pla a significant role in money creation process.Infact they are dealwrs of money creation.The credit is created out of total cadh deposits of the banks.,which are many more timed greater than their initial deposit level.

Money multiplier formula = initial deposit ×1/reserve requirements

As the reserve requirement Decreases, the money supply Increases.

Sources of money to pay for all purchases

* FED creates its sources of money primarily from the interest on US govt securities acquired through open market operations

* Other sources are interest on foreign currency investment held by FED

* Apart from this, fees received for services provided to depository institutions also become the source of money to federal reserve.

This way the federal reserve system injects money in the economy in order to increase money supply .