Who Takes the Hit?
counterfeits of subway tokens and uses them to ride on the
takes the hit? Obviously the subway company does because it will
fewer tokens as a result. Its net profit will decrease by the
the subway rides bought by those counterfeit tokens, less the cost of
them because that reduces the number of tokens it has to produce
Now suppose someone
counterfeits of Federal Reserve notes and spends them into
Is this analogous to the scenario for counterfeit subway tokens?
who takes the hit? As we will see, the case of counterfeit notes
different and much more complex.
It is virtually
impossible to produce
perfect counterfeit notes, but some are good enough to circulate for
periods before they are detected. One million dollars worth of
counterfeit notes would have an imperceptible effect on the
let's assume an amount large enough to have a measurable effect, say
billion dollars worth. That's only about 1% of the cash in
but more significantly it is about 20% of the cash that banks hold.
What Happens to
As the counterfeit
notes are spent into
circulation, the public will find it has more non-interest-earning cash
wishes to hold. So it will deposit the excess cash in bank
it adds to vault cash, and thereby increase the aggregate reserves of
system. Since banks don't earn interest on cash, they will swap
excess cash for deposits at the Fed in order to lend in the Fed funds
to purchase interest-earning assets like T-bills.
Effect of Increased
The increase in
banking system reserves will
create an imbalance in supply and demand and apply downward pressure on
funds rate. In order to maintain control of that rate, the Fed
to soak up the excess reserves by selling some of its own Treasury
to the public. Thus perfect counterfeit notes spent into
increase the public's holding of Treasury securities, and thereby
interest payments due to the public from the Treasury.
Does the Treasury
therefore take the hit?
No, that implies the Treasury is a profit-seeking enterprise, no
that respect from the subway company. The Fed is the source of
money, and Treasury simply recycles what the Fed has previously
Who takes the hit?
In a primitive
counterfeiting would indeed increase the cash in circulation and dilute
value. The holders of cash would then take the hit. But
economies operate mainly on bank-issued credit, not cash.
interest payments owed to the
public by the Treasury resulting from the counterfeit notes must
covered by increased taxes. That's a wash for the public as a
not for those who pay more in taxes than they receive in interest
The net effect is a redistribution of financial wealth within the
sector. It's fair then to conclude that the public takes the hit
counterfeit notes in approximate proportion to the taxes they pay.
The Fed estimates that
over one-half of the
Federal Reserve notes in circulation have migrated overseas for use as
trusted medium of exchange. It is interesting that if, on
genuine Federal Reserve notes return to the domestic economy from
they would have exactly the same effect in the U.S.
as would new perfect