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I saw a link that suggested that when the fed prints money, this money is actually lent to the government in the form of bonds, not given. This, despite the fact that the Fed is (loosely) associated with the government.

My question is...

  1. Is this correct?

  2. If so, how are the interest rates determined?

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The Fed itself does not print anything that’s done by US treasury’s department Bureau of Engraving and Printing.

It is true that Fed decides how much money should there be in circulation through its monetary policy. This also includes ordering treasury to print notes and mint to mint coins although it is worth noting that only small fraction of all US dollars are actually in this form. Most money is created through the fractional reserve system by setting the federal funds rate - a rate at which private banks can borrow money from Fed, and also reserve requirement (although that one is traditionally not used as a policy tool).

It is also true that Fed purchases government bonds and that this is one way how it creates money when governments itself needs them.

The interest rate on government bonds is set by supply and demand. The supply is controlled by the US government issuing its own bonds and demand is created by people or organization wanting to put their savings into these bonds.

The interest rate on these bonds gets smaller if there is high demand for them and vice versa (ceteris paribus). In fact one of the reason why Fed buys government bonds instead of just ordering treasury to directly print money for the US gov. is to create extra demand that lowers borrowing cost of US government.

Also, you should know that all profits Fed gets from the bond interest payments and also other activities are sent to the US budget, or to be more precise Fed sends all its profits to the US treasury which then adds them to the budget, so although Fed technically charges US government that interest it then pays it back to the budget so it’s just juggling the funds around in that case.

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  • $\begingroup$ This is fascinating. But I get the feeling I can't understand it properly without a fair amount of detail. Do you know of any source (maybe a textbook) where I can read more? $\endgroup$ – doublefelix Apr 25 at 10:44
  • $\begingroup$ @doublefelix the process of money creation is described in almost all bachelors level textbooks. For example, Mankiews principle of economics is one place which explains the fractional reserve system. But pretty much any proper bachelor level text should include this so just get one that’s most convenient for you. Some textbooks might not include all the details of how institutions work since some textbooks don’t focus on US but you still get the broad strokes as the fractional system in most countries is very similar with just small institutional details - for example in some countries... $\endgroup$ – 1muflon1 Apr 25 at 12:18
  • $\begingroup$ ... the central banks are more explicitly owned by government etc but most differences are just cosmetic caused by different history. Some central banks such as ECB also have different mandates (Fed must both target price stability and unemployment, whereas ECB only has mandate for price stability), but the money creation works more or less the same way in all fractional reserve systems $\endgroup$ – 1muflon1 Apr 25 at 12:21
  • $\begingroup$ I guess what I am most interested in is an analysis of all the sources of money creation in the US, and how that and other factors can lead to inflation, ideally backed up by historic examples of countries that dealt with high levels of inflation. $\endgroup$ – doublefelix Apr 25 at 12:34
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    $\begingroup$ I will check out Mankiew's principles of economics $\endgroup$ – doublefelix Apr 25 at 12:34
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1) The phrasing you use is somewhat non-standard, but it seems close to the correct view.

The U.S. Treasury borrows by issuing bonds. What people loosely call “printing money” (a badly defined phrase) is that the Federal Reserve buys those bonds from their owners. The original owners of the bonds “lent” the Treasury the money, and the Fed just takes the loan of their hands. The Fed pays for the bond by creating a deposit at the seller’s bank (the central bank is a bank which takes deposits from private banks), and that deposit is considered to be “money” (technically, part of the monetary base).

The Treasury owns the common equity of the Federal Reserve, so to a certain extent, it is one arm of the government dealing with another.

There are plenty of questions on here that discuss “quantitative easing” and give longer explanations.

2) The Fed buys and sells bonds in the market, so it is a market rate.

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