Functions of the Fed: To Create (and Destroy) Money

The Fed is the source of the money supply of the United States. As the central bank of the United States, the Fed has the authority to credit or debit the reserves of banks holding reserves with it. In doing so, it is creating or destroying money in the economy. In the matter of cash, it has the legal authority to issue coin as well as Federal Reserve notes (paper money.)

The revenue the government gains from creating reserves and hard cash is technically known as seigniorage, defined as the revenue gained by the mint from the creation of money.In the days of commodity currencies (gold and silver), the minting of coins added value to each ounce of precious metal by putting it into a form (a coin, such as a sovereign, a ducat, a real or a dollar) which had a readily-recognized value. In other words, the precious metal had been assayed for value, purified and measured into units of a suitable size for commerce. In return for this service, the mint reserved a portion of the coins for itself.

The seigniorage (the profit or revenue from minting) represented the positive difference between the face value (or par value) of the coins, less the value of the metal used to make it.Today, there is no significant portion of United States coinage which is minted from precious metals, and so they have little commodity value.

The seigniorage for paper money is even higher; the value of the money printed in bills far exceeds the value of the linen it is printed on. The actual creation of bank reserves by the Fed is now conducted as an electronic accounting matter, without even the transfer of precious metals between vaults. For all of these (coins, paper, electronic reserves) the ratio of seigniorage to costs is quite high.Since 1971, the world’s major economies have used currencies based on inconvertible paper standards, more commonly known as fiat money. (Convertible paper standards use bills which are redeemable for gold or silver, such as the silver certificates of 35 years ago. “Fiat” is from the Latin for “let there be…”)

Currently, the U.S. government raises about 3% of its revenue from seigniorage. Other first world countries (such as Italy) have been known to raise as much as 10% of government revenue through the creation of money, though the European Union has been an important source of discipline on many central banks. Generally, destructive levels of inflation result from a government’s over-reliance on seigniorage for revenue.

Fed Funds are funds which banks lend each other on an overnight basis to meet the Fed’s reserve requirements. (Most banks must hold cash reserves equivalent to 10% of their transaction deposits, but day-to-day reserves fluctuate based on transactions activities.  

Contrary to popular belief, the Fed does not actually set the Fed Funds rate.  But it has great influence upon it through its open market operations.  For example, if the Fed buys government securities (e.g. Treasuries) from dealers in the open market, the Fed will make payment by adding reserves to the banks where the dealers deposit their funds.

This operation increases the supply of bank reserves, pushing down the yield on Fed Funds loans.  Similarly, if the Fed sells securities it will secure payment by reducing reserves of the banking system, putting upward pressure on the Fed Funds rate.When the Fed announces its monetary policy objectives, it sets a target for the Fed Funds rate.  In then engages in daily open market operations to achieve that target.

If you follow the markets, you will notice that the Fed Funds rate fluctuates quite a bit around the target (currently 1.25%) on a daily basis.The main point here is that the Fed Funds rate is a market rate determined by the demand and supply of overnight Fed Funds loans between banks. You might say, however, that the Fed “owns” (and thus has ultimate control over) this market since the market is created because the Fed maintains bank reserve requirements.

 

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