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Tracing Fiat Money Flows

What is Fiat Money?

Since the end of the gold standard, the definitive money of the U.S. has been credit issued by the Fed. We call that credit fiat money because it is legal tender by government fiat. The Fed creates fiat money mainly by purchasing securities in the open market and crediting the seller's bank with a deposit at the Fed, commonly known as Fed funds or reserves. The bank then credits the seller with an equal deposit in his transaction account.

Fiat money exists in only two forms -- as entries on the Fed's computer, and as Federal Reserve notes and minted coins. The Fed computer entries are the record of deposits, most of which are owned by banks and the Treasury. The notes and coins are simply fiat money in tangible form. Banks can exchange them for Fed funds on demand. Unlike a bank, the Fed has no capital ratio constraint and can therefore issue credit without limit.

Banks also issue credit, but are limited by the capital ratio requirement. They do so by lending and simply crediting the borrower with a deposit in his account. Bank deposits are claims on fiat money rather than actual fiat money. However a deposit covered by government insurance is as creditworthy as fiat money. When a depositor makes a payment by check or electronic means, the payer's bank debits his transaction account and surrenders that amount of reserves to the payee’s bank which then credits the payee with an equal deposit.  

Effects of the Financial Crisis

The Fed's response to the financial crisis of 2008-2009 greatly expanded its balance sheet and changed many long term practices. Before the crisis, banks held very few excess reserves and received no interest on reserves from the Fed. Notes were by far the largest component of fiat money. As of March 2007, notes totaled about 770 billion. Banks held 50 billion of the notes and 20 billion in Fed funds, both of which count as reserves. The Treasury held 5 billion in its General Account out of which all payments are made. In spite of the large preponderance of notes, most of the fiat money flow involves the transfer of deposits on the Fed’s computer. 

Since most pre-crisis conditions will likely be restored at some future time, we will assume the conditions that existed before the crisis. We will focus on the fiat money flow between the government and the private sector, and largely ignore flows within the private sector. Fiat money plays an indispensable role there, but mainly in interbank transfers of reserves to settle payments, and in retail payments with notes and coins.  

A Simplified Model of  the System 

We simplify by assuming the U.S. has only one bank, which has just two accounts. One, called the public account, holds the transaction deposits of the entire non-bank public. The other is where the Treasury deposits its receipts from taxes and the sale of securities, called the Treasury Tax and Loan account (TT&L account). It holds the bulk of the Treasury's available funds. but is used only as a buffer rather than a transaction account.

We also assume the Fed has just two accounts. One holds the bank's reserves and the other holds the Treasury's deposits out of which all government spending is paid. The latter is known as the Treasury general account. The Treasury continually replenishes it from its TT&L account.

We will observe two constraints based on normal operating conditions in the U/S. monetary system: (1) The bank maintains a fixed ratio between its reserves and the combined transaction deposits of the public and Treasury. (2) As it spends, the Treasury transfers funds from its TT&L account to maintain a fixed balance in its general account.

Two Flow Scenarios

First let's look at the flow of funds when government spending is matched by equal revenues, i.e. the budget is balanced. As the Treasury spends, the bank's reserves and the deposits in the public account increase by the amount of its spending. Tax payments transfer equal deposits from the public account to the TT&L account, with no change in reserves. As the Treasury restores the balance in its general account with transfers from its TT&L account, both accounts in the bank return to their original balances.

Now let's look at the flow of funds when government spending exceeds tax revenues. As the Treasury spends, the bank's reserves and the deposits in the public account increase by the amount of its spending. However tax payments transfer a lesser amount of deposits from the public account to the TT&L account. As the Treasury restores the balance in its general account with transfers from its TT&L account, the latter suffers a net reduction in its balance. That scenario could continue only as long as the balance remained positive.

The Reciprocal Flow of Fiat Money

To avoid a continual drain on its TT&L account, the Treasury sells securities as needed to recapture its deficit spending. That restores the TT&L account and public account to their original values. If the Treasury continually sold fewer securities than that, it would deplete its TT&L account. If it sold more than that, it would accumulate deposits in its TT&L account at the expense of the public account. In effect, the government pays for its deficit spending with Treasury securities rather than fiat money. 

The Treasury has no incentive to accumulate funds from security sales in excess of what it needs to cover its deficit spending. That would add to its interest costs unnecessarily. Thus the reciprocal flow of fiat money between the Treasury and the private sector remains balanced on average at the rate of government spending. Note that the public gains in net financial wealth as the government deficit spends.

The Growth of Fiat Money

In both scenarios above, the Fed acts primarily as a depository and clearing agent. It has no reason to add or drain fiat money. Growth in the fiat money supply is normally the result of private sector demand rather than government spending. When the public draws on its bank deposits to hold more currency, the bank must acquire new reserves of fiat money to back its remaining transaction deposits. If the public desires to hold more transaction deposits, it can seek additional bank loans or draw on existing savings and term deposits. In either case, the bank must acquire new reserves to meet the reserve ratio requirement. Since the Fed is the only source of new reserves, it normally responds by purchasing securities in the open market. If it failed to meet the demand, it would lose control of the short-term interest rate, its primary monetary policy tool.

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