How does the [USA] fed increase or decrease the amount of cash in circulation?

Question

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

Answer 1

Start with the fact that commercial banks (not the Fed) have to hold money for transactions. However, they don’t like holding money, because they’d rather hold an asset that provides some return (even a small return).

So if a bank has more money than they legally need to hold, they may purchase a safe asset like a Treasury bill. But they can’t tie up their money for long (maybe they’ll need it tomorrow), so they might do what’s called a reverse repurchase (reverse repo) agreement: they agree to buy a safe asset, and then sell it back for a slightly higher price in the near future.

On the other side of this deal might be a bank that needs more money overnight. So they agree to sell their asset and buy it back tomorrow at a slightly higher price. This is a repurchase (repo) agreement. They are basically taking out a short-term loan.

That loan has an implicit interest rate. If they sell a Treasury bill for $100 and agree to buy it back tomorrow for $100.01, it’s an overnight rate of .01%, or about 3.7% annually.

This is where the Fed comes in. There is a large repo market in the US, so the Fed tries to get that market rate (3.7% in my example) close to the target Fed funds rate. The Fed can do either a repo or a reverse repo, depending on how they’re trying to move the interest rate. The Fed is really targeting the interest rate, not the amount of money, but a Fed repo will take money out of the banking sector (banks get the asset, Fed holds the money), and a Fed reverse repo does the opposite (Fed gets the asset, banks hold more money).

That’s one of the big ways. It gets complicated. The Fed can now pay interest on deposits that banks hold at the Fed (that used to not be true). It has recently bought/sold other longer term assets. And it can loan money directly to banks through the discount window, although historically that’s been pretty rare.