I’ve heard that this happens through banks, but what financial mechanism is used to do this? It can’t simply be “Hey Chase Bank, here’s $100 million for free”.
In: 14
Imagine the Federal Reserve as a central bank that owns a) a very large hypothetical sack of cash and b) large holdings of Treasury bonds.
If you aren’t familiar with bonds, they are a promise to pay – e.g. $1 invested in a bond with 1 year maturity at 5% interest rate means that next year, you expect $1.05 back.
When the economy slows down or is in a recession, we wish to stimulate the economy. One way the Fed does this is by using some of that cash to buy more Treasury bonds. Since that sack of cash has just been sitting in the Fed but is now in circulation, the money supply has increased – the Fed has “created money”. However we can’t simply create money out of nothing. The Treasury has to pay the Fed back (along with interest) when the bonds expire, where the amount owed is considered part of the “national debt”.
In the opposite case, when the economy is booming and getting inflationary, we wish to slow the economy down. One way the Fed does this is to sell some of their Treasury bonds that they previously bought. They take the cash from the sales and add it back to their sack of cash, which decreases the money supply – the Fed has “destroyed money”.
In practice, all of this is done electronically of course in the modern age.
Latest Answers