|Tracing Fiat Money Flows
is Fiat Money?
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
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.
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
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.
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.
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.
observe two constraints based on normal operating conditions in the
system: (1) The bank maintains a fixed ratio between its
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
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
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
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.
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
scenarios above, the Fed acts primarily as a depository and
agent. It has no reason to add or drain fiat money. Growth in the fiat
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.