Most people believe the central bank prints the money. In a modern economy, this is wrong. Most money is created by commercial banks when they make loans; the central bank sets the price at which those banks can borrow reserves and the rules under which they must hold them. This lesson walks the plumbing without myth.
- 01Explain the role of the Federal Reserve (and central banks generally).
- 02Describe fractional reserve banking in balance-sheet mechanics.
- 03Distinguish the monetary base from broader money supply aggregates (M1, M2).
- 04Explain how interest rates are set at the short end and transmit to the rest of the economy.
The Federal Reserve
The Fed is the central bank of the United States. Its three statutory jobs are to maintain price stability, to promote maximum employment, and to keep long-term interest rates moderate. It does this by setting the price of reserves (the federal funds rate target), by supervising banks, and by acting as lender of last resort in a crisis. It does not, day to day, print the currency the public spends — that is the Treasury — and it does not, in the modern regime, control the total quantity of money in circulation.
Fractional reserve banking
A commercial bank takes deposits and makes loans. It is required to hold only a fraction of the deposits as reserves — the rest is lent out, and the loan proceeds are themselves deposited (often in another bank) and re-lent. Through this process, a single dollar of central-bank reserves supports many dollars of deposit money in the wider economy. Modern regulation focuses less on a reserve ratio and more on capital ratios, but the multiplier logic remains.
The money supply
Economists distinguish the monetary base (currency plus bank reserves at the central bank) from broader aggregates. M1 adds demand deposits — the money households can spend today. M2 adds savings deposits and small time deposits — money households can spend soon. In every developed economy, the broad aggregates are many multiples of the base, because the base has been leveraged by the banking system.
Interest rates
The central bank does not set most interest rates directly. It sets a target for the overnight rate at which banks lend reserves to one another, and it manages market operations to keep the actual rate near the target. Everything else — the mortgage rate, the corporate bond yield, the credit card rate — is a spread over some benchmark that ultimately references the overnight rate, adjusted for term, risk, and liquidity.
- The central bank sets the price of reserves; commercial banks create most of the money.
- Fractional reserve banking multiplies base money into broader aggregates.
- Monetary base ≠ money supply. M1 and M2 are the household-relevant measures.
- All interest rates are, in the end, priced off the overnight rate the central bank controls.
- Bank of England, 'Money creation in the modern economy' (2014) — The single clearest short paper on how bank lending creates money.