The Federal Reserve acquires its unique powers through its ability to issue money. Open your wallet or your purse and take a look at some bills. At the top, you will see the words “Federal Reserve Note.” In the past, many banks issued their own bank notes, which were used as money. But today the money we use in the United States is provided by just one bank, the Federal Reserve. Thus, the Federal Reserve has the power to create money—an awesome power that forms the centerpiece of this chapter. The Fed doesn’t have to literally print money. It can, as we shall see in more depth later in this chapter, also create money “by computer” by adding reserves to bank accounts held at the Fed. This new money can be given away or lent out in a way that increases aggregate demand.

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If the Federal Reserve is a bank, who are its customers? The Fed is both the government’s bank and the banker’s bank. As the government’s bank, the Fed maintains the bank account of the U.S. Treasury. When you write a check to the IRS to pay your taxes, the money ends up in the Treasury’s account at the Fed. In addition to receiving money, the U.S. Treasury also borrows a lot of money and the Fed manages this borrowing—that is, the Fed manages the issuing, transferring, and redeeming of U.S. Treasury bonds, bills, and notes. Since the U.S. Treasury is by far the world’s largest bank customer—it has more income and it also borrows more than any other bank customer—the Federal Reserve is a large and powerful bank.

In addition, the Fed is also the banker’s bank. Large private banks keep their own accounts at the Fed—in part, because some banks are required to hold accounts with the Federal Reserve and in part because other banks and financial institutions want a safe and convenient place to hold their money. The Fed also regulates other banks and it lends money to other banks. Finally, the Fed manages the nation’s payment system—the system of accounts that makes it possible to write checks from one bank to another—and it protects financial consumers with disclosure regulations. Many of these and other duties are shared with other state and federal agencies.

Now that we know what the Fed is, let’s turn to its most important function: regulating the U.S. money supply. But first we have to understand what the money supply is.