Where does the Prime Rate Interest go and How Does the Federal Reserve Create New Money?

 

The Federal Reserve pays interest on reserve balances to commercial banks and other eligible institutions that hold accounts at the Federal Reserve Bank (.gov). This interest, known as the Interest on Reserve Balances (IORB) rate, is set by the Board of Governors of the Federal Reserve System (Board of Governors). The IORB rate is a key tool used by the Fed to influence the federal funds rate, which is the interest rate banks charge each other for overnight loans. 

Here's a more detailed explanation:

The Federal Reserve, the country's central bank, is not a government entity, despite the name Federal. The "Fed" is self-funded: It mostly gets its operations and salaries covered via interest from securities that it owns as part of the Fed's open market operations (OMO).  

 Interest on Reserve Balances (IORB)

Commercial banks are no longer required to maintain reserve balances at the Fed. However, they are incentivized to do so because the Fed pays them interest on the amount they hold in reserve. This interest is credited to the banks' reserve accounts, essentially creating money. The banks can then use this money in loans, which creates more money out of the created money. 

This, in turn, ultimately adds more to circulating money as funds are deposited and loaned again

IORB is the primary tool the Fed uses to keep the federal funds rate within the target rate range. The central bank sets the IORB rate so that banks must decide whether lending money to other banks or leaving funds in their reserve accounts and generating interest income is more profitable.

The Federal Funds Rate, as it was known prior to 2019, was an interest rate set by the Fed.  To encourage banks to lend to each other, and to affect how money is created, the Fed publishes a target rate which is used by banks as a guide for all other interest rates, and it also helps dictate how much money is being created.

With the monies deposited with the Fed, the Fed may purchase securities or other financial instruments to stabilize the financial market. 

Does the Fed Create New Money?

Yes, but the Fed does not print paper money. That is handled by the Treasury Department's Bureau of Engraving and Printing. 

Does the Fed Make a Profit?

The Fed earns interest on securities held and through fees. Once it pays its expenses, it turns over all remaining funds to the U.S. Treasury. In 2025, the annual salary for the Chair of the Federal Reserve Board is $250,600, and the annual salary for the other six governors is $225,700 which are included in expenses. In addition, they receive health insurance and retirement benefits.

There are 12 regional Reserve Banks that work independently with oversight from the Board of Governors in Washington DC. The Reserve Banks are the operating arms of the Federal Reserve System and function within their own geographical Districts. The Fed identifies its districts by number and the city in which its main office is located. Each Reserve Bank has a nine-member board of directors that serves as a link between the Federal Reserve and the private sector. Directors come from a range of backgrounds.

Summary 

By paying interest on reserves, the Fed incentivizes banks to hold reserves at the Fed rather than lending them out to other banks at a lower rate. This has the effect of creating new money out of the credited interest.  It also sets the base market interest rates to the rate the Fed is paying because  banks do not want to lend at a rate lower than it can receive from on its reserves from the Fed. The fed may use the deposits to purchase other financial instruments.

 Posted by Rob Taylor, editor