This post is the second in a series exploring how the U.S. economy’s primary financial institutions, the Federal Reserve, the U.S. Treasury, and the commercial banking system — operate, and how their decisions directly impact the building industry and BuildUSA. Post 91: The Fed, Treasury, Monetary Policy and BuildUSA introduced the key players. This post goes deeper into one of the most important and least understood topics in economics: how money is actually created.
More Complicated Than You Think
Most people assume money is created by the government, printed at the Mint and distributed from there. That is partially true, but it is only a small piece of the picture. The reality is that the vast majority of money in circulation today is created digitally, through the lending activities of banks. Understanding how this works, and who controls it, is essential for anyone trying to make sense of interest rates, inflation, and the broader economic forces that shape the building industry every single day.
There are two primary sources of money creation in the U.S. economy: the Federal Reserve and commercial banks. They operate differently, use different tools, and serve different functions, but they are deeply interconnected.
Part 1: The Federal Reserve — Creating the Foundation
As introduced in Post 91, the Federal Reserve is the central bank of the United States. One of its most powerful and least visible roles is its ability to create money. The Fed does not print dollar bills per se, that is done at the U.S. Mint, but it controls the foundation of the entire money supply by managing bank reserves. Here is how it does it:
Currency in Circulation
This is the most familiar form of money creation. Physical bills and coins are printed and minted, then distributed by the Federal Reserve to commercial banks in exchange for reserves those banks hold at the Fed. The banks then distribute the cash to businesses and individuals through normal banking activity. Simple enough, but physical currency actually represents a relatively small share of the total money supply.
Open Market Operations (OMO)
This is the Fed’s primary, day-to-day monetary policy tool.
Process: The Fed purchases U.S. Treasury securities or agency mortgage-backed securities (MBS) from banks or the public. Payment is made by crediting the purchasing bank’s reserve account at the Fed, essentially, new digital money is created on the spot.
Effect: Bank reserves increase and the banks have greater capacity to make loans and the broader money supply expands.
Open Market Operations are also the mechanism behind Quantitative Easing (QE), where the Fed executes large-scale, sustained asset purchases (typically buying bank held Treasuries and Mortgage-Backed Securities (MBS)) over an extended period. This typically happens when short-term interest rates are already near zero and traditional tools lose their effectiveness. QE injects significant liquidity into the banking system, encouraging banks to lend to businesses and consumers and stimulating broader economic activity.
The reverse, Quantitative Tightening (QT), occurs when the Fed sells assets or allows them to mature without reinvesting, pulling reserves out of the system and contracting the money supply.
Discount Window Lending
Process: Banks can borrow directly from the Federal Reserve at the “discount window.” The Fed credits the borrowing bank’s reserve account with the loan amount.
Effect: Reserves in the banking system increase, supporting new lending capacity. Discount window borrowing is used primarily for short-term liquidity (typically overnight) needs or during periods of financial stress, the Fed acting as the lender of last resort.
Interest on Reserve Balances (IORB)
Process: The Fed pays interest on the reserve balances that commercial banks hold at the Fed. By raising or lowering the IORB rate, the Fed directly influences banks’ incentives to hold reserves versus lending them out.
Effect: This is an indirect but powerful lever. Lower IORB rates encourage banks to lend rather than sit on reserves, expanding the money supply. Higher IORB rates do the opposite.
Emergency & Special Lending Programs
During periods of acute financial stress, the Fed can deploy targeted lending facilities. Examples include the Term Asset-Backed Securities Loan Facility (TALF), the Commercial Paper Funding Facility (CPFF), and central bank swap lines extended to foreign central banks. These programs temporarily increase reserves or liquidity in specific markets and can indirectly expand the broad money supply as institutions lend and spend.
A Key Point About Fed-Created Money
All of the money the Fed creates is, initially, digital reserves, not physical cash. It exists as entries on a balance sheet. When commercial banks lend against these reserves, it multiplies into the broader economy as M1 and M2 (more on that below). Equally important: money is also destroyed , when loans are repaid or the Fed sells assets back into the market, the money supply contracts. Creation and destruction are two sides of the same coin.
Part 2: Commercial Banks — Where Most Money Is Actually Created
Here is the part I think will surprise most people. The majority of money in the U.S. economy is not created by the Federal Reserve. It is created by commercial banks, through lending.
Every time a bank issues a mortgage, a car loan, a commercial business loan, a personal loan, or extends a credit card line, it is creating new money. The bank does not lend out money sitting in a vault, it credits the borrower’s account with new funds, which then circulate in the economy. The loan itself is the new money.
A few important dynamics to keep in mind:
As loans are repaid, that money is effectively removed from the economy, the principal paid back to the bank disappears from the money supply. The interest paid, however, is different. Interest is income to the bank and continues to circulate; it is not destroyed. And banks are always operating within constraints, reserve requirements, capital ratios, and the Fed’s policy tools described above set the limits. The Fed creates the foundation; commercial banks build on top of it.
This is why the building industry and all the loan activity it creates is such a large driver of the economy and is so sensitive to interest rate decisions. When the Fed raises rates, borrowing becomes more expensive, commercial banks issue fewer loans, and less new money enters the economy. The impact on construction lending, development financing, and real estate markets is direct and immediate, and all of us in building have felt it. Don’t forget, the Building loan activity is not just the construction loans used to build or renovate structures, but also the loans required to fill these buildings with furniture, equipment, and the business or personal operations that occupy the space.
Part 3: How Is the Money Supply Tracked?
The Federal Reserve tracks and publishes several measures of the money supply, commonly referred to as “aggregates.” Understanding these measures helps make sense of economic reporting and the policy decisions coming out of the Fed.
M0 — The Monetary Base: Physical currency in circulation plus total bank reserves. This is the money created directly by the Fed the foundation of the entire system.
M1 — The Most Liquid Money: Currency in circulation plus checking deposits and demand deposits. This is the money people and businesses can spend immediately, and it is the most direct measure of day-to-day economic activity.
M2 — Broader Purchasing Power: M1 plus savings accounts, small time deposits (like CDs under $100,000), and retail money market funds. M2 provides a wider picture of purchasing power in the economy and is one of the Fed’s most closely watched indicators.
M3 — The Broadest Measure: (discontinued by the Fed in 2006 but still estimated privately): M2 plus large time deposits, institutional money market funds, and other large liquid assets. M3 provided the broadest view of credit and liquidity in the system. Its discontinuation remains a point of debate among economists.
M4 — The Widest Lens: (not officially tracked by the Fed): M3 plus all other liquid assets, including short-term repurchase agreements, commercial paper, and Treasury bills held outside the banking system. When estimated by private economists, M4 offers the most comprehensive view of total liquidity in the financial system, a useful lens when assessing the full scope of capital availability in the broader economy.
Why Does This Matter for Building?
The building industry is one of the most capital-intensive sectors of the U.S. economy. Every project, from a single-family home to a large commercial development, depends on the credit markets that the Fed and commercial banks together control. The mechanisms described in this post are not abstract economics. They are the upstream forces that determine whether capital is available, at what cost, and in what volume.
Related Posts from Steve’s Build Blog:
• Post 91: The Fed, Treasury, Monetary Policy and BuildUSA — Introduces the key financial institutions and their roles in the U.S. economy.
• Post 89: BIM, BCE & Data Mining — Explores how BuildUSA’s platform harnesses data to improve building project outcomes.
• Post 87: BuildUSA – Big Data — Examines the potential of big data within the building industry and how BuildUSA’s data structure supports it.
Post 93: Definitions & Acronyms: This post is a compilation of this information and provides both definitions and acronyms of some of the commonly used terms used within the Build Blog.
• Post 96: BuildUSA’s Collaborative Environment (BCE) – Can It Work? — Explores how digital collaboration within BuildUSA’s platform can transform project team coordination.
Photo by Logan Voss on Unsplash