and the Money Supply
to conventional wisdom, the Federal government spends taxpayers'
money. In reality tax revenues normally cover less than government
spending, and the difference is covered by the sale of Treasury
average its inflows are balanced by outflows, and the private sector's
net financial wealth gains by the amount of Treasury securities
Managing the Base Money Supply
Treasury pays the government’s bills out of its account
at the Fed. Those payments inject new reserves of base money into
the banking system. Since the increase in reserves would interfere with the Fed’s ability to
implement monetary policy, the Treasury compensates as follows:
(1) As the Treasury spends, it
replenishes its Fed account with equal transfers from its commercial
accounts where it deposits its receipts from taxes and bond sales. This removes the reserves of base money created by its
spending. Aggregate reserves of the banking system therefore remain
unchanged on average, thereby allowing the Fed to make small adjustments in reserves as needed to maintain control of the Fed funds rate.
The Treasury replenishes its commercial bank accounts with the
receipts from taxes, and from the sale of bonds when there is a shortfall in
tax revenues. If tax revenues exceed its spending, it removes the
surplus by net redeeming its securities. In this way it minimizes
disturbances to the aggregate bank deposits of the private sector.
The Balanced Reciprocal
Flow of Funds
effect, the Treasury simply recycles base money previously created by
the Fed. Its outflows and inflows move bank deposits and reserves
around the banking system without changing the total on average. The
Treasury has no use for balances in its own bank
accounts in excess of what it needs to cover its near-term payments.
It normally holds about one month's worth of government spending, which
currently averages about $300 billion.
long term increase in the public's money supply is due to
(1) net borrowing from banks and (2) the increasing demand
currency. As the money supply increases, the Fed must inject
reserves into the banking system to balance supply against demand at
its target Fed
Funds rate, its primary monetary policy tool. It
by purchasing Treasury securities held by the public.
Why the Treasury Can
Always Sell its Securities
As long as the Federal
government enforces tax collection, its base money will be in demand.
Since base money
earns no interest, when the private sector has more than it desires to
hold in the aggregate its
only interest-earning alternative is Treasury securities. The Treasury
can pay whatever interest rate the market demands, so there will always
be willing buyers of its securities.