The Fed expands the money supply through a couple of methods. For simplicity, let's consider "security purchasing." When the Fed wants to expand the money supply, it buys a security -- let's call it Asset A -- from a bank. Then it electronically transfers money to that bank. There is now additional money in the financial system that the bank can use to provide loans.
The nice part about being the Fed is that it doesn't actually need to mail a box of dollar bills to pay for these securities. Instead, it creates a "reserve balance" liability on its balance sheet. The transaction is completely electronic. No hard currency changes hands.
Then, when the Fed is ready to reduce monetary supply, it sells Asset A. This puts the security back into the financial market and reduces money in the system, again electronically. Is that money destroyed?
On the one hand, the money no longer exists in the financial system. On the other hand, it was only there temporarily in the first place. When the Fed gets that money back, it merely reduces the size of its reserve balance liability. In a sense, money is only "created" during an expansionary cycle electronically, through an accounting mechanism. It's then "destroyed" in a similar, but opposite, accounting entry.
When Currency Is Physically Destroyed
Obviously, not all money is electronic. Just look at your wallet. Bills and coins are destroyed every day. There are three destroyers of money, and they're the same ones who create and regulate it.
(1) The Bureau of Engraving and Printing and (2) The U.S. Mint
The U.S. Bureau of Engraving and Printing creates all of the nation's bills, while the U.S. mint creates its coins. But they also destroy money.
Banks and individuals will hand over "mutilated" bills and coins to these agencies. They then validate its authenticity and issue a Treasury check in return. The Bureau of Engraving and Printing receives around 25,000 mutilated currency redemption claims annually. Each bill is shredded and sent to waste energy facilities for disposal.
(3) The Federal Reserve
The great regulator of money distributes currency through its 30 Federal Reserve Bank Cash Offices, after receiving it from the Bureau of Engraving and Printing. But it also destroys currency that it wants taken out of circulation and replaced with fresh money.
The Fed is diligent about keeping our currency fit since a torn or mangled bill can't go through an ATM, a vending machine, or another electronic reader. As a result, the average life of each bill is surprisingly short:
- $1 bills: 3.7 years
- $5 bills: 3.4 years
- $10 bills: 3.4 years
- $20 bills: 5.1 years
- $50 bills: 12.6 years
- $100 bills: 8.9 years
Overall the average life for all bills is about five years.The Fed occasionally has some reason for accelerating the rate at which money is taken out of the system, like when a new bill design is introduced. But generally, a banknote's fitness determines how long it remains in the financial system.