Marketplace Whiteboard®

A little help here, please

Paddy Hirsch Oct 6, 2010

So, I’ve been racking my brain to find a good and simple way to explain the relationship between the Fed and the Treasury. And it turns out I may have not quite understood that relationship as well as I thought I did.

So I’ve been trawling the Web for some good explanations, and come up dry. This is the best one I’ve found – what do you all think of it?

The Treasury physically prints hard currency, but cannot add it to its own coffers. The Fed can create money, but it cannot physically print currency.

If the government needs more money, it issues bonds. Investors (including you and me) can buy a bond and essentially become lenders to the government. The government must then pay interest to those investors. Once all is said and done, the investors receive their principal back plus interest. The Treasury issues those bonds. The Fed, acting as the government’s bank, handles all the money transfers. The government pays the interest from tax revenues.

Hard currency is just a form of cash. If there is demand for more hard currency, the Treasury prints it and hands it over the Fed. The Fed then gives out the currency to banks but it doesn’t add to the cash value, so no money is created. If banks are out of cash, then they give the Fed securities of equal value, which net out against the cash received.

The way money is created is through the multiplier effect whereby banks lend money, someone makes a profit and pays employees, those employees spend the money, etc. A bank that receives $100 in deposits and loans out $80 just created $80 of new money. The problem is that too much lending creates too much money, which creates inflation. Conversely. too little lending can cause economic contraction and deflation.

In order to control money supply, the Fed can adjust the reserve requirement, the discount rate, or act in the open market to control the fed funds rate (what banks charge each other). In the open market, the Fed can buy Treasuries from banks and increase cash, or sell Treasures to banks and reduce cash. Banks can’t lend out Treasuries, so a reduction in cash slows down loans, which slows down money creation. If supply of cash goes down, interest rates go up in the short run and discourage borrowing. When the Fed holds these Treasuries (Treasury bills, notes, and bonds), it earns interest from the government.

If the Fed earns more interest than it needs to run its operations, it returns the excess to the government. Since the government is getting some of its interest back, it essentially gets an interest rate free loan. The Fed only holds a small portion of total outstanding Treasuries.

So what happens if the Fed runs out of cash to buy Treasuries? Well, the Fed can create cash out of thin air. If it needs to be in hard currency, it simply asks the Treasury to print more. While that might lower interest rates in the short run and stimulate the economy, it can create nasty inflation in the long run. That’s why the Fed is independent and doesn’t take direction from the government.

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