Recently I have talked a lot about the Fed printing money and flushing the system with liquidity. I have been using the term liberally, as it is easier to visualize a printing press, minting money, than the open market operations and other things, that the Fed carries out to actually create liquidity in the economy.
So, here is a brief and simple explanation of how it works.
How does the Fed create liquidity?
Open Market Operations
The most frequently used tool for creating money is Open Market Operations (OMO). Open Market Operations refer to the Fed buying and selling government securities in the open market, in order to increase or decrease money supply.
If the Fed has to increase money supply it buys government securities, and if it has to decrease money supply, it sells government securities.
For example, let’s say that the Fed gets it trading desk at the New York Fed to buy government securities from dealers. Because they bought securities from them, they will credit the dealer’s bank accounts.
Now, since the banks have more funds deposited with them, they have more funds to lend and so “new money” is created in the economy.
To take a few numbers, if the Fed bought securities worth a million dollars, the banks have a new million dollars to loan out from. By lending out this new million, the banks have created funds in the system which were not existent earlier.
Decreasing Reserve Requirements for Banks
Banks have to keep some amount of their deposits with the Fed as a measure of safety. If the Fed wants to create money in the economy, it can reduce the reserve requirements of the bank. When it reduces the reserve requirements, banks can keep less with the Fed and spare more to lend. Since, they have more to lend, than they had earlier, this creates money in the economy.
Central Banks in every country of the world have reserve requirements, for example in India, this rate is known as CRR.
Lowering Interest Rates
This is not exactly creating money, in the context that it is being used today, but, lowering interest rates is also a very frequently used tool by the Fed to create liquidity. By lowering interest rates, it makes money cheaper and therefore facilitates lending.
After a certain point, lowering interest rates stop working (the Fed can’t lower the interest rates below 0) and in such times, they resort to other means lsuch as the ones mentioned above.