How money is created today

How money is created today

 

The United States of America, central bank is the Federal Reserve Bank, the Fed. While it has several “tools” at its disposal to increase and decrease the nation’s money supply–create new money and withdraw money from circulation.  Fed created money is called “base money” or permanent money to distinguish it from commercial bank created money called “bank money.” The Fed essentially creates new money by buying assets. Normally those assets are U.S. Treasury obligations. When the Fed wants to shrink the money supply (destroy money) it sells assets. When the Fed buys assets it can simply make a bookkeeping entry crediting a bank’s or a securities dealer’s account with new money. It doesn’t even have to go through the pretense of having the Bureau of Printing and Engraving pint new money or the U. S. Mint stamp out new coins, a simple bookkeeping entry suffices. If physical money is desired, wanted or needed, the Fed simply orders what it needs from the Bureau of Printing and Engraving and/or the U. S. Mint.

 

When the Fed wants to decrease the money supply, destroy money, it sells assets in its inventory, to whit assets it originally bought to create base money.

 

Most Americans learn about the Fed in school. However, the mechanism is so simple and transparent that most Americans think it is more complicated than it is. The complication comes in the details of managing the money supply in an attempt to manage interest rates and avoid things like inflation, bank failures and recessions/depressions.

 

The basic mechanics of creating new money, however, are fairly routinized. The Fed buys assets from a bank or securities dealer. In each case money is now available on a commercial bank’s books or account at the Fed. As we shall see later, the commercial bank is then in a position to use this new money (actually, base money), as a basis for making loans. The lent money is new money, for the original deposit of base money remains undisturbed as an entry on the bank’s books and technically still available for use by the owner of the account. Indeed, the loan proceeds will likely be deposited in another account and serve as the basis for yet another loan (and more newly created money). This lending by banks is called the multiplier, for it allows the original base money to act as if it were many times larger than the original deposit made by the Fed when it purchased the asset from the bank or securities dealer.

 

The money created by commercial bank loans eventually disappears as it is repaid. But, if the money is lent out again quickly its temporary disappearance will go unnoticed.

 

Nominally new, durable money created by the Fed is called base money; and, new, temporary money created by commercial banks is called bank money. If you need a dollar for a cup of coffee, either base or bank money will do the trick as a dollar is just that, a dollar, no matter how it was created.  And in your hands one can not tell the difference as the are the same,

 

The problem with base money is that it starts life as a deposit in either a commercial bank’s or a security dealer’s account. To have any impact on an average citizen’s, consumer’s or working person’s life base money has to be loaned to someone with a payroll or a major purchase in mind or construction needs-things that result in employment. It could well be that a whole string of loans involve refinancing, debt service or a highly liquid asset purchase (or, God forbid, purchase of ancient artifacts). In short, base money creation takes time and a series of transactions before it trickles down to the average working stiff. This is ironic for it is the spending habits of the average working stiff and his or her family that drives the economy. Yes, a firm such as Monsanto has a billion dollar balance sheet, but unless Joe Blow and his family have the $2.98 for a loaf of bread on a regular basis Monsanto will go belly up for lack of clients (agribusinesses of all sizes) for its bio-designed wheat seed.

 

As we shall see later, money in the hands of citizen consumers is where the economic action is. We will return to central banks later. They will become a real key to economic growth and stability-for real. Unless the reader misses the innuendo, central banks are not presently a key to economic growth and stability.